This is the first in a 7-part update series on FSG’s 2017 Events to Watch. Additional updates can be found below:
In December 2016, FSG released the report Events to Watch for 2017, which profiled the major disruptors that multinational companies should evaluate to ensure the resiliency of their strategic plans. As part of a series of blogposts we seek to review and update FSG’s view on the likelihood, impact, and signposts to monitor for each of the seven disruptors we profiled in the report. This post will evaluate the downside disruptor “China Loses Control.”
Events to Watch for 2017: China Loses Control
In 2015, the Chinese government responded to fears of a slowing economy by selling foreign currency reserves to stabilize the yuan, imposing capital controls, and pumping credit into the market. These measures staved off a hard-landing but exacerbated existing property and credit bubbles. The government will seek to manage these building pressures, but it is possible that crises in the real estate and financial markets could overwhelm a financial system already burdened by bad debt. The resulting declines in spending and confidence could exceed the central government’s ability to compensate with fiscal stimulus, forcing banks and state-owned enterprises into bankruptcy and driving government credibility to new lows. In turn, declining demand in China would negatively affect global demand.
Event’s Impact on Market Potential and Operating Environment
- Economic decline among commodity-exporting countries: a slowdown in China would decrease demand for commodities, especially hard metals
- Global FX volatility: the renminbi would likely devalue steeply, causing ripple effects among other emerging-market currencies
- Increased political risk: a severe decline in growth would increase pressure for abrupt policy changes by the government to mitigate declining popular legitimacy
- Growing impetus for greater reform: Chinese policy makers would face greater pressure and need for reforms, including the privatization of certain SOEs and improved access for foreign firms into protected industries such as the financial sector
Signposts to Monitor Revisions
China has yet to see a rapid property price decline or an acute credit crunch, our two signposts to watch for this event. The People’s Bank of China (PBcC), China’s central bank, raised short-term rates several times during the first quarter of 2017. Ostensibly in line with rate hikes by the Federal Reserve and a stable Chinese economy, the rate increases are also designed to contain excessive credit growth in the real estate and financial sectors.
Real estate: The Chinese real estate market has remained buoyant, despite attempts by the government to contain excessive growth. In addition to increasing interest rates, the government has ordered trust companies to curtail lending to the real estate sector, vowing to take action against companies that subvert the regulations. Although access to mortgage rate discounts has tightened, they remain widely available.
Financial sector: Although the government has asserted that non-performing loans have not reached critical levels, growth in lightly-regulated shadow banking has continued. Low interest rates have driven growth of Asset Management Products (AMPs) which were worth 80% of China’s $11 trillion gross domestic product in June 2016. Over 40% of these AMPs are off-balance sheet, making them difficult to track and regulate. Although there is a significant maturity mismatch between the assets and liabilities in AMPs, it is a widely-held belief that the government will prevent banks from failing should a liquidity crunch occur.
To dispel these perceptions, Chinese financial regulators have issued new regulations instructing banks to report off-balance sheet AMPs. These regulations have prompted banks to deleverage from off-balance sheet investment vehicles, resulting in the recent stock market sell off that sent bond yields soaring. Although the government is cracking down on excessive credit growth, they have also signaled their commitment to moderating market volatility by providing liquidity. In March, the PBoC injected liquidity after a few lenders failed to make payments in the interbank market.
A China Loses Control event was originally forecast at a probability of 35%. We are not changing this probability for several reasons. First, there has not been a rapid property price decline or an acute credit crunch, our two event triggers. Second, the government’s crackdown on excessive lending should help alleviate the pressure building in the real estate and financial markets, making a China Loses Control event less likely. However, by injecting liquidity to prevent excessive volatility, the government is also perpetuating the housing and credit bubbles, making the event more likely. Third, the recently released financial regulations are an important step towards improving the resiliency of the banking sector and defusing the risk of a downside scenario.
It remains to be seen whether the government will bail out banks in the event of large-scale failures. A complete bailout of the banking sector would fail to address the root causes of the credit bubbles and could make a financial crash more likely in the future. Although letting a few banks fail could create short-term financial turmoil, it would address the drivers of financial instability, and ultimately make a larger crash less likely. If the Chinese government is materially able to curb credit growth through the new regulations or allows a few banks to fail, it would reduce the likelihood of a China Loses Control scenario substantially.
Actions to Take
Multinationals should be prepared to deal with a downside scenario arising from a bursting housing bubble or a credit crunch in the Chinese financial market. Our previous blogpost details how MNCs can prepare for tightening money market conditions. FSG’ s Events to Watch for 2017 report also provides in-depth scenarios, expected impact on business performance and operations, as well as recommended frameworks for contingency planning and effective market monitoring.
FSG clients can access the Events to Watch for 2017 report here.