IT’S THE YEAR OF THE ROOSTER – NOW DON’T COCK THIS UP, CHINA

31st January 2017

According to the traditional Chinese calendar, on Saturday 28 January the Year of the Monkey gave way to the Year of the Rooster. Last year started badly and ended well. We think that this year will do the opposite.

A slowdown in the Chinese economy remains, as ever, the single biggest risk for the Australian economy. We have often stated that Chinese GDP growth is slowing over the long term because the structure of the Chinese economy is changing – services now outweigh manufacturing industry as a percentage of GDP, state sponsored capex is declining, and labour supply is moving from surplus to shortage.

These long term structural changes do not augur well for Chinese purchases of Australian coal and iron ore, which are mainly used by the construction and heavy industry sectors. The outlook is further complicated by rising Chinese debt levels (see chart below) and falling Chinese foreign exchange reserves. This does not mean that China is about to have a financial crisis. Chinese debt is mainly held by the corporate sector, which makes the Chinese situation unlike recent financial crises. The core problem for the Global Financial Crisis was very high household debt (e.g. highly geared home loans), and the core problem in the Greek banking crisis was excessive government debt.

The problems of Chinese companies with too much debt were all too visible in a wave of bond defaults and insolvencies in 2016. The Chinese system for handling insolvencies relies on committees of creditors, local governments and the Communist Party (!) which focus on keeping enterprises going in some form, rather than on returning money to creditors. Creditors have very few rights in practice, and often suffer haircuts or forced debt-to-equity swaps. The dominant role of the central government in the banking system means that China will not have a “Lehman moment”, where a systemically important institution has an uncontrolled meltdown which reverberates through the financial sector.

Although the central government has kept a tight grip on insolvencies so far, it is far from assured that China will avoid financial turbulence. The steady fall in the Chinese yuan against the currencies of its trading partners is clear evidence that a lot of capital is running away from China as fast as it can. Chinese foreign exchange reserves peaked at nearly USD$4.0 trillion in June 2014, but by December 2016 reserves had dwindled to USD$3.0 trillion as the Chinese authorities sold foreign currency in order to manage an orderly slide in the yuan. It is widely believed that China will have to devalue by 10% or more before it reaches a stable exchange rate.

A new threat has appeared – a trade war. President Trump has threatened at various times to impose a tariff of 20% to 45% on Chinese imports. This would not only raise prices for US consumers, it would also provoke retaliation from China. In the eleven months to November 2016, the US bought USD$423 billion worth of Chinese goods, but China also bought USD$104 billion worth of US goods.

Of course, the Chinese government would prefer to hold the moral high ground, rather than impose a tit-for-tat tariff on imports from the US. It is likely to retaliate more subtly, by moving against US companies which operate in China or sell to China. These companies could find themselves on the receiving end of tax audits, anti-trust inquiries, or corruption investigations. There are many US companies which derive a large percentage of their sales from China. For example:

  • Apple: 20% of sales (and Chinese contract manufacturers such as Foxconn)
  • Boeing: 13% of sales
  • Caterpillar: 20% of sales
  • General Motors: sells more cars in China than in the USA
  • Texas Instruments: 60% of sales

Because goods exported by China are often composed of parts and materials from neighbouring countries, any reduction in Chinese exports to the US implies not only lower production in China, but also less imports of parts and materials from countries such as Vietnam, South Korea, Taiwan and Malaysia. Because these countries are also major export customers of Australia, Australian exports would suffer demand falls not only from China but also from its neighbours.

2017 is an important year in Chinese politics, in ways which make a financial crisis less likely but a trade war more likely. The Communist Party is holding its regular series of regional meetings which will culminate in a party conference in October to choose the leaders for the next five years.

It is a foregone conclusion that Party head and State President Xi Jinping will remain top dog until 2022 at least. The important decisions are about who is his colleagues will be, and whether Xi will continue as “core leader” after 2022. In order to demonstrate unity and a smooth transition, the Party has re-activated Deng Xiaoping’s old mantra – “stability is paramount”.

This means that there will be no financial crises or popular disturbances (even if growth has to be a little lower). It also means that the Party would welcome a US trade war, which it could use as a propaganda tool – waving the patriotic flag discourages dissent. Any US action against China’s artificial islands in the South China Sea would also help the Party to whip up nationalist sentiment.

Therefore we think that, although 2017 opened with roosters crowing about new US share market records, the year may end with the roosters in the pot. 鸡年大吉! Good luck for the Year of the Rooster!

Q.E.D.