CHINESE DOWNTURN A BRIEF BACKGROUND

So I hear a lot about China these days? What is going on?

Gone are the days when the headlines used to be about stratospheric Chinese growth
figures (China once posted 14% real GDP growth just before the financial crisis; a
number high enough for Narendra Modi to go into a tizzy). Welcome to the new world
of falling Chinese growth rates. This year, China is expected to post the slowest growth
in 25 years. So how bad is it?
On paper, the country is still growing fast. Its GDP growth meter clocked an impressive
6.9% in the Third Quarter of FY 2015. This is a far cry from a recession or even a sharp
slowdown for a country as big as China. However, beyond the headline number,
Chinese story, for certain, has taken a darker turn. The official data showed that the
manufacturing sector shrank for a fifth straight month in December. The official
manufacturing purchasing managers index for December came in at 49.7 slightly
above Novembers performance (A reading below 50 implies a contraction, while a
reading above 50 suggests growth). Chinese car sales have decelerated quite a bit,
growing just 4.7% YoY in 2015 against a growth of 9.9 % in 2014 (The year before that,
it was a breath-taking 16%). Annual growth of fixed asset investment, a crucial driver
of China's economy, likely eased to 10.2 percent in 2015 - the weakest expansion in
nearly 15 years (Reuters). Annual PPI (Producer Price Inflation) was 5.2 per cent down
year on year in 2015 while CPI rose a mere 1.6% in December, well below the official
target of 3%.
Sorry!! But wasnt that expected? After all, there are only a limited
number of farmers to be moved away from agriculture to more
productive sectors.
True, it was expected. As a country becomes
richer, the capacity to catch up reduces (Right way
to think about is this: If I am a very poor country
of, say, per capita GDP of $1500, then I can easily
utilise low-cost labour advantage to boost my
export and grow. As a result, I can grow fast. As
my manufacturing sector starts to grow, I can
move people from less productive sectors such as
farming to more productive sectors such as
manufacturing and services. This rise in
productivity accelerates the pace of GDP
expansion. However, after a while, labour cost
catches up, and you lose that lever of GDP growth
[Another way to think about is that they are no
more underemployed peasants to be moved in more productive sectors. This is also
called the Lewis Point]. This is the classic "Middle-Income Trap". Quite a few
countries have fallen into this trap (literally an entire continent and a few more). Some
of the Latin American countries such as Brazil grew quite spectacularly in the 1960s
and 1970s and then just stopped growing. Additionally, the Chinese economy is heavily
investment led which is yielding decreasing returns. China has debt equivalent to
250% of its GDP, a comparatively high figure for an economy at a similar development
stage. More alarming is the speed at which it has risen, which is often a predictor of a

financial crisis. Finally, there is the small question of ageing demographics. The
scrapping of "One Child" policy may have come too little too late.
However, the question mostly revolves around the way China will move to a lower
paced growth scenario. Will it be abrupt or more of a smooth landing? The former
entails quite a few risks. A sharp slowdown may trigger widespread protests (Chinese
have grown accustomed to a high growth economic landscape. For them 2% growth
rate may indeed be as severe as a recession elsewhere) and devoid Chinese People's
Party of political legitimacy. This may further induce more risk in Chinese economic
climate and will lead to widespread panic among investors. The abrupt capital flight
may indeed make the doomsday scenario a reality (even if fundamentals don't warrant
it)
Okay!! But what is about their Stock Market? It seems that every other
day, there is a historic fall in Chinese Stock Exchanges.
While Chinese may love their Confucian lineage and celebrate themselves as the
Middle Kingdom, they must be scared of the word "historic" nowadays.

Fig 2 & 3 (Source: Financial Times)

There are several reasons as to why Chinese Stock Market is in a tailspin. The most
recent one involves the use of new Circuit Breakers which were designed to reduce
market volatility and ended up, instead, exacerbating it [Apparently Magnet Effect
dominated the trading due to low trigger mark]. Circuit breakers lasted for a total of
3 days (Jan 4 Jan 7) and enjoyed 29 minutes of fame, but did great damage to the
reputation and credibility of Chinese policymakers. The initial collapse was initiated

due to PBOC setting renminbis peg lower than expected (Which meant devaluation
and was taken as a signal of weakening growth momentum). However, there seems to
be confusion in this regard. For making renminbi an international reserve currency,
PBOC ceased its control of setting a direction for the renminbi movement and instead
follows a complicated mathematical model to set the new peg taking into account
recent movements. In fact, PBOC has spent to the tune of $200B to prop up the
renminbi. The exchange rate of renminbi in the offshore market (Hong Kong), where
officials cannot meddle with, is even lesser [ i.e. more devalued] than that of the
domestic market.
The more fundamental reason seems to be the case that Chinese Stock Markets are
grossly overvalued and in a dire need of correction. However, the correction will sap
domestic investors income and may affect consumption (Y = C + G + I +NX).
Furthermore, China has a huge shadow banking sector that is essentially
unregulated and could easily experience a wave of bank runs in case of increased
default due to market correction. Hence, the government wants to prop up the stock
market with its state intervention in the market, both directly as well indirectly. They
have taken many action with the net result inducing only more panic and fear among
the investors.
But hey isnt Market Rational? Fundamentals must back this, right?
Well, only Fama and Schiller could actually answer it. But Chinese markets are a
complex beast. There are quite a lot of conflicting interests and state intervention to
make it a rational beast. And it gyrates way more than Madhuri Dixits hips.
But why should we care? To hell with China and their stock market.
Arent we supposed to rejoice at their failures? What happened to
geopolitics?
Well no; Quite the contrary. Before we start indulging our schadenfreude tendencies,
we should be reminded of the fact that China today is the second largest economy in
the world. The International Monetary Fund expects the country to account for almost
18 percent of global economic activity in 2016. This implies that the drop in its growth
rate from an expansion of more than 10 percent in 2010 to 6.3 per cent expected this
year has directly knocked about 0.75 percentage points off the global growth rate. A
more immediate effect has already been felt around the world due to sell-off in major
stock exchanges. This may already doom the future of fragile global recovery (As the
luck would have it, The famed Soros (George Soros) has already declared 2016 as the
year of next global financial crisis; although there are enough critics of this argument
for the moment). As the global economic climate becomes gloomier, money would
start to leave risky emerging markets, periling the economic growth of these countries.
Commodities exporting countries such as Brazil, South Africa and to some extent
Australia will be particularly hit hard. India will not be left untouched either. Flight of
foreign capital will mean low FDI and capital investment will be kept on held. This
may also further exacerbate the NPAs of leading banks. All these will mean disaster
for Make-in-India campaign and will reduce GDP growth rate in the short term. But
among these dark clouds, there are a few silver lining. Oil has already hit new lows,
and if the global economy doesn't improve, it may further tumble along; all of which
will be sweet music to Arun Jaitely and fiscal planners in North Block.