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Why one bank thinks China's markets could unravel

After rattling financial markets for large swathes of last year, it didn’t take China’s economy long to resume that role in 2016.

In just one session – less if you count China’s stock market having to close early to prevent even greater losses – the second largest economy in the world wrought havoc, rattling markets around the world.

It was certainly not the start to the trading year that many had expected.

While the volatility in Chinese markets has ebbed today, not everyone believes the relative calm in China will last.

According to David Cui, Tracy Tian and Katherine Tai, China equity strategists at Bank of America-Merrill Lynch, financial system instability in China is likely to be the rule, rather than the exception, in the year ahead.

The crux behind their call is China’s ballooning private sector debt. Here’s BAML:

China’s private debt to GDP ratio rose by 75 percentage points between 2009 and 2014, by far the highest among the 40 economies with data (together with HK). At the peak speed, over the 4 years from 2009 to 2012, the ratio in China rose by 49 percentage points. Historically, any country that grew debt this fast inevitably ran into financial system problems, including currency devaluation, banking recap, and high inflation, and we do not expect China to be an exception. We believe that the government had maintained system stability over the past few years by allowing various implicit guarantees to get firmly entrenched, which has made the financial system fragile. This is a classic case of short term stability breeding long term instability, in our view.

This chart from BAML shows the growth in private sector debt in the five years between 2009 to 2014, expressed as a percentage of GDP. Clearly there were two standout performers who racked up debt at a breakneck pace over the selected time period.

Cui, Tian and Tai believe investors have become complacent about the potential for increased instability, and have been lulled into a false sense of security as a result of various short-term solutions introduced by the government to stymie volatility.

Avoiding a sharp slowdown in GDP growth by running pro-growth macro policies. Allowing the renminbi to gradually appreciate against the US dollar, at least until recently. Continued support for the nation’s stock and property markets. Avoiding a major debt default, shielding those who were unable or unwilling to effectively price risk appropriately to escape with their capital intact.

See the common theme? They’re all designed to protect investors and, in some instances, have lead to reckless levels of speculation.

Cui, Tian and Tai suggest that the longer this practice is allowed to drag on, the higher the risk of financial system instability, and the more painful the ultimate fall-out will be.

It seems to us that the government’s policy options are rapidly narrowing – one only needs to look at how difficult it has been for the government to hold up GDP growth since mid-2014. A slowdown in economic growth is typically a prelude to financial sector instability. Putting it all together, it seems to us that many of these conflicts may come to a head in 2016.

Even without factoring in a rapid increase in financial instability, BAML doesn’t pull any punches when it comes to the outlook for Chinese stocks and the renminbi in the year ahead. They’re bearish.

They believe onshore traded A-shares “remain expensive”, forecasting that the benchmark Shanghai Composite index will drop to around 2,600 by the end of 2016, representing a decline of some 30% from its 2015 closing level.

On the renminbi, they forecast that the USD/CNY will hit 6.9 by year’s end, up from its present level around 6.5150, with risks to their forecast “on the downside, possibly substantially.”

They also suggest that the belief the government has the will and the resources to manage a gradual renminbi devaluation, and as a side effect capital outflows, as “questionable.”

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