The most likely trigger for a China hard landing is policy error with miscalculation of how much financial risk management or structural reform the system can absorb, and if not managed properly, capital outflows and external debt risk could inflict severe pain on the financial system.
That’s the view of Michaela Marcussen and Wei Yao, economists in Societe Generale’s cross asset team, who suggest there are three obvious triggers, combined, that could spark a so-called “hard landing” for China’s economy.
The first is a credit crunch in China’s financial system, something they believe could eventuate from an intensification of capital outflows, a growing number of non-performing loans and an insufficient policy response from the PBoC.
Marcussen and Yao suggest that these risks could be exacerbated by pressure coming from Chinese corporations’ foreign exchange denominated debt and overall high level of leverage, something that is demonstrated in the chart below that captures total non-financial debt levels as a percentage of GDP.
The second risk they see comes from faltering demand for housing.
“Recently, housing prices in tier 1 cities have enjoyed something of a boost, but tier 2 and tier 3 remain lacklustre,” they note.
“Should a new shock emerge, triggering a buyers strike, then real estate developers could suffer renewed stress, triggering a significant scaling back of investment.”
The third risk Marcussen and Yao see stems from large excess capacity in China’s manufacturing sector, something they believe would be exacerbated further in the advent of a hard landing, weighing on corporate margins and profits which in turn would see a rise in corporate bankruptcies and unemployment.
“In response to a hard landing scenario, Chinese policymakers would be forced to make difficult choices, either to succumb to the temptation of a short-term boost via new infrastructure build out or pursuing a reform agenda, Marcussen and Yao note.
“In reality, there would likely be a combination, but we consider each choice separately for the purpose of analysis.”
Under such a scenario the pair believe economic growth would slow to just 3% next year, less than half the level targeted by the Chinese government this year. They also suggest the Chinese renminbi would weaken weaken significantly, suggesting the USD/CNY could rise to as high as 7.5 by 2017 from the 6.356 level it currently sits at today.
Currently, Marcussen and Yao’s base case scenario is not for the economy to suffer a hard landing, attaching just a 10% probability of it occurring. Instead, their most favoured option is for the economy to suffer a “bumpy landing”, a scenario where they expect further short-term weakness in the renminbi, but where policy actions will be sufficient to avoid disorderly capital outflows.
Although far removed from what markets have come to expect over past years, such an outcome may be just about as good as one could expect given heightened concerns that have rattled markets over recent months.