China Fault Lines: Where Economic Turbulence Could Start in 2016

  • Dollar strength, quickening capital outflows among key risks
  • Corporate defaults may profilerate, triggering more bad loans

China's Challenges: Key Themes to Watch in 2016

China’s leaders are striving to cut leverage while restructuring growth away from an over reliance on investment and toward greater consumption and services.

Sounds simple. But there’s a risk the transition triggers a steeper slide in growth in 2016. Things could also go awry if there’s an acceleration of capital outflows, corporate defaults that trigger more bank bad loans, or increased turbulence in the shadow banking industry, according to economists and analysts interviewed by Bloomberg.

QuickTake China's Pain Points

While pundits don’t necessarily expect such outcomes, these are the areas they flagged as having potential to trigger a plunge in growth or systemic risk in the financial system. 

Currency Turbulence

The strength of the dollar is the biggest uncertainty for 2016 because it will impact capital outflows, add to deflationary pressures, impact corporate earnings and economic growth, said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong.

A strengthening greenback means domestic companies with dollar debts will face higher repayment pressure, while the central bank will spend reserves smoothing the depreciation path, causing money supply to shrink and constraining banks’ ability to roll over credit, says Victor Shih, a professor at the University of California at San Diego who studies China’s politics and finance.

"Academic economists in China are already debating the relative merits of a smooth devaluation" versus a rapid, maximum one, said Shih.

Quickening Outflows

"The biggest headache for the government next year is accelerated capital outflows," said Pauline Loong, managing director at Asia-Analytica Research in Hong Kong. "And dealing with it in a way that will not make things worse by giving the wrong signals, as it did with the stock market rescue this year."

A Bloomberg measure of estimated capital outflows indicates more than half a trillion dollars has left the country in the past four months alone.

Outflow pressures complicate policy making, says Loong. She says if the central bank lowers interest rates to support the economy, dollar assets will look even more attractive; if it intervenes in currency markets to prop up the yuan, exports will be hurt; if it tightens up capital controls, people will try to flee before it’s too late.

"Beijing is caught between a rock and a hard place," she said.

Empty Houses

The biggest downside risk for the economy is if the absorption of an excess supply of housing turns out to be deeper and more protracted, triggering a knock-on effect on industrial output and investment, said Wang Tao, chief China economist at UBS Group AG in Hong Kong. A lack of policy support could exacerbate the situation, she said.

"Either could aggravate the negative feedback loop in weak real activity, worsening deflationary pressures and increasing debt burdens, all against a backdrop of higher capital outflows and financial market volatility."

Defaults, Loans

Economic bumps in 2016 will be all about "the banks, the banks, the banks," says Andrew Polk, an economist with the Conference Board in Beijing.

"We’re going to see a proliferation of defaults or near defaults that are going to have to be worked out," he said. "Stress in the corporate sector is where the exposure of the banking system is and that’s just been building and building and building. Profits in the industrial sector continue to deteriorate and we have more and more companies operating at losses."

At some point, a smaller city commercial bank is likely to go belly up. The only question is whether it’s bailed out quietly behind the scenes or allowed to formally fail, said Polk.

Shadow Banking

Problems in the shadow banking sector "are close to certain" next year as liberalized deposit rates intensify competition for savings and a crackdown on their role intermediating capital outflows triggers redemptions of their investment products, says Alicia Garcia Herrero, chief Asia Pacific economist at Natixis SA in Hong Kong.

Base Case

Even without any of the above scenarios blowing up, growth is forecast to slow to 6.5 percent in 2016, according to the median estimate of economists surveyed by Bloomberg. To prevent a quicker fall, policy makers must navigate across multiple fault lines.

— With assistance by Kevin Hamlin

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