The wild cards that could send China into a tailspin aren't looking that wild

It hasn’t been 2 weeks yet, and 2016 has already been a difficult year for the Chinese economy.

The country’s major stock indices have declined around 15%, and the Chinese yuan has depreciated 1.5% against the US dollar.

Key economic indicators look weak, and overcapacity and debt are major structural issues.

But there’s still hope policymakers can manage the situation.

Unless, of course, things get out of control.

In her 2016 outlook, star China analyst Charlene Chu of Autonomous Research outlined a number of possible “wild cards” that could push this situation beyond repair.

The thing is, right now, a lot of the wildcards don’t look so wild.

Here’s the rundown from Chu’s report:

  • Further expansion of deflationary pressures to the broader economy that would begin to undermine the values of all assets, most importantly property, and lead to a change in behaviour throughout all levels of the economy;
  • A shift in focus of the corruption crackdown to the banking sector, including branch managers and credit officers, which could bring a rapid halt to the rollover of some credits and more hesitation to extend new credit amid an economic slowdown;
  • Increased international trade frictions from a depreciating CNY and increased dumping of excess goods in international markets;
  • Bond market volatility that leads to losses in banks’ securities portfolios and off-BS [off balance sheet] wealth management products, leading to an unwind of the second balance sheet;
  • Stress in Hong Kong, where a significant change in the investment or business climate and/or a loss of confidence could spark a large outflow of funds as has happened on occasions in the past. Growth of Hong Kong’s banking sector has been extremely brisk over the past decade, and large outflows could be destabilizing.

Lets go over Chu’s risks point by point.

  • On Monday we got an indication that deflationary pressure is still present. The country’s consumer-price index came in well below the government’s 3% target at 1.6%. More importantly, the producer-price index — which tracks wholesale prices for companies — came in at -5.9% It’s the 48th consecutive month PPI has been negative.
  • President Xi Jinping’s anti-corruption campaign has made waves in the financial sector, with a number of high-profile bankers finding themselves caught up in the operation. The campaign hasn’t yet extended to smaller actors in the banking sector, but the probe is ongoing, so stand by on that one.
  • All of the pressures forcing the yuan down a week ago — including deflationary pressure and thinning corporate margins — are still very much in play. The Chinese government set the yuan higher on Monday, but the negative PPI read was a signal that the government will likely continue depreciating the currency to make goods more competitive. The lower the yuan goes, the more tempting it is for neighbours to lower their currencies as well.

    YUAN/USD ChartGoogle FinanceA year in the yuan/USD
  • We’ve talked a lot about how much China’s corporate bond market has exploded over the last year and change. The government has kept interest rates low to keep money flowing through the economy and cash poor, debt-laden corporations are taking advantage.
  • Hong Kong hasn’t been destabilized by any means, but its main stock index — the Hang Seng — is down almost 6.5% for 2016 and a Hong Kong reserves of the yuan have hit a two-year low. Analysts expect Hong Kong’s economy to slow.

As you can see, there are a lot of moving parts here. For example, the country needs the yuan lower to be competitive, but it doesn’t want to set its neighbours off. It needs companies to stay alive, but it also needs to cut off the spigot of easy debt that’s accumulating on everyone’s balance sheets.

I would not want to be a Chinese central banker this year. Too much devil in these details.

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