With the volatility in emerging markets over the past year, many investors and analysts (especially those in the developed markets) may ask whether China is the third leg of the financial crisis after the US in 2008 and Europe in 2011. When assessing China’s outlook, one must keep things in perspective. I do not believe the country would be a trigger for another financial crisis, for several reasons. China has an expanding current account surplus, net foreign direct investment inflows and US$3.8 trillion in foreign exchange reserves (which is more than 40 percent of GDP).
Unlike the US and Europe, China’s financial linkage with the world is limited, owing to its closed capital account. This means the country does not depend on foreign savings and investment, as does much of the global economy. Local government liabilities and non-performing loans are thus a domestic problem — a substantial problem to be sure, but China’s leadership will deal with them internally with the major resources it already has on hand.
Crucially, China has very small foreign debt (about 0.3 percent of GDP), and almost all debts (both domestic and foreign) are denominated in renminbi (RMB). With a closed capital account, a small debt burden, little foreign borrowing and its enviable position as a net creditor to the world, the country is unlikely to be a trigger for a global financial crisis.
It is true that China has accumulated a lot of debt in just a few years, with total credit in the economy now accounting for over 200 percent of GDP and shadow banking activities thriving. However, Beijing is aware of the problem and is starting to deal with it. This is why Chinese growth is slowing down sharply, but naturally, relative to its past record because of structural reforms and deleveraging. The impact of this on the world economy is mainly through a reduction in demand for commodities.
The Chinese economic downturn has nothing to do with problems in other emerging market economies, many of which suffer from high fiscal and current account deficits, insufficient foreign exchange reserves, high inflation and reliance on foreign capital inflows to fund economic growth.
To be sure, China does face a number of risks — shadow banking, local government debt, rising bond yields and a property bubble, to name some of the more notable, but these are not the sources of the nation’s economic downturn. Instead, China has targeted a structurally slower growth trajectory to accommodate pressures from its planned economic and policy re-balancing. This process is not a source of another round of global financial crisis, but a planned program for addressing long neglected internal economic and policy needs that, when met, will result in a much stronger role for China on the global economic stage.
Investors should see China’s structural reform program as an opportunity to realize long-term gains from the short-term pain this country will experience as it goes through creative destruction to rebuild a stable and productive nation. Inevitably, these reforms will cause disruptions and accompanying ‘outsized’ headline news, many of which would not be positive, suggesting avoidance of China during this transition period.
To the contrary, investors should embrace the volatility in China’s growth and asset prices in the transition process and build positions and exposure to Chinese assets. The fact that China has changed and is changing cannot be disputed. Experience teaches us that all periods of instability offer investors opportunities that they rarely see in the early stages.
Those who are able to remain calm and buy on the dips will likely prosper when instability gives way to new value. Albert Einstein once said: “In the middle of difficulty lies opportunity.” The difficulties that China will be going through in transition to a stronger and better economy may well present many investment opportunities that can be realized in the coming years.