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Fragile - Why China’s debt crisis could hurt your portfolio

Daniel Liberto asks if 2019 could be the year China's economy finally cracks, and what – if anything – investors should do about it
Fragile - Why China’s debt crisis could hurt your portfolio

When China sneezes, companies across the world now reach for a tissue. Just over half a century ago nobody seemed to bat an eyelid when 36m Chinese people died in the great famine. Fast forward to today and investors are fretting over whether the Chinese buy a cup of coffee, designer handbag or the latest smartphone.

Equity markets hit the panic button after some of the world’s biggest companies, including Apple (US:AAPL), Starbucks (US:SBUX), Samsung and Volkswagen (GER:VOV3), blamed cash-strapped Chinese consumers for their recent woes. Those warnings pummelled global indices, shooting down suggestions that China and the rest of the world aren’t inextricably linked and reopening up the decade-long question that economic prosperity in the promised land may finally be unravelling.

 

Could this be the year when it finally all cracks?

China is known for overestimating its growth rate, so when government officials revealed that gross domestic product (GDP) rose 6.6 per cent last year, the slowest rate in almost three decades, many began wondering how bad the situation actually is. The corporate world helped to fill in the blanks, inciting panic and making even the seemingly outlandish claim from Xiang Songzuo, a finance professor and former chief economist of China Agriculture Bank, that GDP may have been as low as 1.7 per cent suddenly seem not so far-fetched.

 

 

Investors won’t be alarmed that China’s economy is slowing. The country is growing from a much larger base and is in the middle of an important transition. Neighbouring regions can now offer cheaper labour, putting China’s decades-long status as the world’s workshop under threat and forcing it to switch from an export-led economy to one that depends more on domestic consumption.

Still, assuming that Mr Xiang is wrong and independent economist estimates that GDP grew closer to 5 per cent are closer to the truth, there are plenty of warning signs to suggest that something is amiss.

Following the 2008 meltdown of the western financial system, Beijing ordered its state-owned banks to increase lending. China’s addiction to debt-funded construction of new cities and infrastructure to prop up its economy has become a thorny issue. Money was mainly funnelled into inefficient state-run companies, rather than the dynamic private sector, and saturated in sectors such as real estate, where demand is limited.

Now that it’s no longer as easy to export surplus production to other countries, the worst possible scenario is playing out: massive investments are delivering the ugly combination of ballooning debt and slower growth. China’s households, government and corporations have debts totalling almost three times the size of GDP, making the country the second-most indebted nation in the world, behind Japan.

 

 

Without the rapid growth and high tax revenues of yesteryear, the government faces a tough task servicing repayments without borrowing more. Efforts have been made to wean the country off fiscal stimulus and clamp down on a worrying rise in unregulated lending facilities. Those measures backfired in 2018, pushing up borrowing costs, dampening investment and bruising domestic demand. The word on the street is that the average Chinese person is no longer living lavishly, buying only the absolute necessities. Reduced spending power has already made its way to official data: retail, property and auto sales all slowed in the final quarter of 2018.

Rising unemployment and stagnant wages are also the symptom of a trade war with the country’s biggest partner. Donald Trump is slapping tariffs on Chinese goods, hurting the nation’s exports and its job prospects.

Beijing responded to these challenges by promising yet another round of fiscal stimulus. In January, the country’s central bank pledged to spend more on infrastructure, trim income and corporate taxes and relax some restraints on lending.

Analysts are confident that a record $83bn (£64bn) injection into the country’s financial system will lift economic activity by the end of the year, even if there’s evidence to suggest that efforts to channel more funds into struggling corporations face big hurdles.

Reuters reporters in China recently claimed that banks are wary of taking on more bad debts, amid a long regulatory crackdown. They also noted that businesses are hesitant to make new investments when sales are faltering.

Over the next few months it should become clear whether Beijing’s latest attempts to juice growth rates and prevent a cash crunch have the desired effect. Reopening the same old credit lines and ploughing more capital into poorly managed construction projects looks like a temporary fix at best.

Economists calculate that incremental nominal GDP growth has lagged total debt service payments each year since 2012. If Beijing doesn’t soon put its money to better work and find a sustainable solution to keep state-run companies above water without regular injections of cheap credit, China’s economy looks destined to eventually hit a brick wall.

The government has proved time and time again that it can overcome whatever challenges are thrown at it. Yet if gross debt continues to rise, its sweeping control over the banking system, untapped fiscal capacity and vast ownership of domestic and foreign assets might no longer be enough to prevent its financial system from collapsing.

 

How would a China recession impact the rest of the world?

Shortly after China reported its weakest annual growth since 1990, the International Monetary Fund (IMF) slashed its global GDP outlook for the next two years by 0.2 and 0.1 percentage points, respectively. Economists worry that the world, already rocked by Brexit uncertainty, sluggish growth in Europe and the advancement of populist political parties, would be unable to handle a bigger than expected slowdown in the People’s Republic.

That logic can no longer be argued with. China is now the second-largest importer of goods and services in the world. The country’s $12 trillion economy powers around a third of global growth, making it as much a locomotive as the US. Jobs, exports, stock markets and entire nations, including the UK, now all depend on China buying stuff.

 

UK contagion risk

The People’s Republic is the UK’s sixth-largest trading partner, accounting for 7 per cent of UK imports and roughly 4 per cent of exports. The relatively low number of UK goods shipped to China has led some commentators to rubbish suggestions that falling demand would have a notable impact on Britain. Maybe they overlooked the considerable indirect trade links between the two countries, or that Downing Street is pinning its hopes on closer trading relationships with the world’s second-largest economy after Brexit.

Last year, the Bank of England (BoE) claimed that a 10 per cent fall in Chinese national income would lead the UK economy to contract by 1.4 per cent. This impact, they added, could be doubled if it was “amplified” by financial markets.

 

SECTORS WITH MOST AT STAKE

Banks

In its research paper, the BoE warned that UK bank ties to mainland China and Hong Kong “exceed exposures to the US, euro area, Japan and Korea combined”. Much of this exposure is on the balance sheets of emerging-markets-focused banks Standard Chartered (STAN) and HSBC (HSBA) – The Hong Kong and Shanghai Banking Corporation (HSBC) has retail and commercial banks in China, as well as joint ventures in asset management and insurance.

HSBC has already warned that demand for credit in the Asian financial hub is tailing off and cautioned, together with Standard Chartered, that trade wars are leading some clients to pull money out of investments. A wider global economic slowdown, triggered by China’s problems, would amplify those risks across the entire banking sector.

 

Commodities

China, home to almost one-fifth of the world’s population, is a big consumer of raw materials, buying up nearly half of global output of pork, steel, copper, coal and cement. That means that if the country runs into trouble, commodity prices are likely to fall, squeezing the profits of their producers and the health of the many nations whose economies are propped up by exporting them.

In the UK, London-listed miners are particularly at risk. Since 2006, a one standard deviation fall in China’s manufacturing purchasing managers' index (PMI) led stocks in the sector to drop almost 25 per cent. This indicates just how much demand in the country has a bearing on the welfare of the industrial metals market.

 

Engineers

The nation’s engineers were identified as the second most vulnerable to swings in China’s manufacturing output – and with good reason. The likes of IMI (IMI), Rotork (ROR), Spirax-Sarco (SPX) and Weir (WEIR) made a killing during China’s investment boom years, selling critical components for big infrastructure projects. Replacing this level of high-margin work isn’t easy, even if there are other countries with similar expansion plans.

Fresh stimulus should move China’s industrial output out of contraction territory over the next few months. The problem is that the country’s 'Made in China 2025' plan champions self-reliance. Beijing wants to avoid importing foreign equipment by encouraging its companies to create their own specialised engineering solutions.

That’s not all UK industrials have to worry about. When raw material prices tumble, demand for the goods used to help extract them tend to plummet as well, indicating that a China slowdown could tarnish sales prospects everywhere.

Many British engineers are also a key part of car and plane supply chains. China is the world’s biggest auto market and a key source of investment for aerospace companies, too – about one of every four jets that Boeing (US:BA) builds is currently bound for the country.

 

Luxury goods

Cars and plane tickets aren’t the only things the Chinese buy when their economy is strong. Consumers there were responsible for roughly a third of the $121bn spent on luxury goods worldwide in 2017, meaning there’s a lot at stake for various other sectors as well.

Retailers, for example, rely on the Chinese jetting around the planet to purchase fashionable western goods. They account for more than a fifth of the money spent annually by outbound tourists, nearly twice as much as the next biggest spender, the US. Some iconic UK brands have sought to capitalise by setting up shop on the mainland. Burberry (BRBY) has stores there, while Diageo (DGE) uses distributors to sell its popular whiskies in the country.

Semiconductor makers and other companies that help furnish smartphones and various tech gadgets have already been warned that the Chinese are turning their back on expensive, foreign-made products. Tech juggernaut Apple inadvertently made it clear that the country’s residents now find better value in locally crafted smartphones, such as those made by national champion Huawei.