Dragon taming

If we are to learn from past experience, market fears will be alleviated later in the year and a crash landing of the Chinese economy in 2014 seems unlikely.

There are valid reasons for investors to be concerned. Recent economic data has not been brilliant. Figures on industrial production, retail sales and fixed asset investment were all lower than expected for January and February. The industrial production numbers are perhaps the most troubling, given that this data series closely tracks the GDP figures, and a weaker first-quarter growth number is now widely anticipated.

Fears over a hard landing for China economically this year are, however, overdone. The authorities have plenty of levers to pull to kickstart things if the situation becomes too dire. But investors should be prepared for a gradual easing in growth in the country over the coming years, which will be a by-product of the structural shift taking place as the government pursues economic and financial reforms.

Reform

At the National People’s Congress earlier in the month, the top priority was reform. However, even in the pursuit of reform, the key economic targets of growth, inflation and money supply were unchanged from last year. The implication is that the government is endeavouring to maintain stable growth in 2014, and the risk of aggressive reforms that would endanger this is low.

Then there is the issue of credit, and fears of a rash of defaults on bonds and wealth management products, following the recent corporate bond default by a small solar energy company – the first in China’s history. Many commentators have been calling the risk of bond defaults the country’s “Lehman moment” – the point in time when everything begins to fall apart. Looking at the current situation, it would be easy to come to that conclusion, with a total debt to GDP ratio approaching 250 per cent (which includes government debt) and the recent bond default both pointing to an overly leveraged economy. The existing debt levels are the result of China’s response to the 2008 global financial crisis, which included mass stimulus and credit creation through banks, while the growth in the shadow banking sector was encouraged by the government as a means to reduce reliance on the main banking sector. True to form, this shadow banking initiative was very lightly regulated.

Much of what the Chinese authorities are currently implementing – including the decision to allow debt defaults, where previously the government would have stepped in to intervene – is designed to unwind the misjudged policies that were put in place in the wake of the financial crisis. The question is: how well can the government manage the slowdown in credit creation without tripping it up completely?

Risk

A consequence of the tighter credit conditions will be an increase in the number of bond defaults. Each potential default is most likely to be judged on its own merits along with the impact it may have on the wider financial market. It is possible that the authorities will be more willing to let go the less systematically important companies with professional investors as creditors, rather than the wealth management products owned by the general public. Over the longer term, the practice of allowing corporate default will mean that more risk will be priced in and markets will become more disciplined in their investment practices.

Moreover, the Chinese government’s desire to balance near-term growth with reform suggests that aggressive action to de-lever the economy is unlikely, as is a sharp downturn in growth. Investors should remember that China remains a managed economy and the government or central bank will step in to steady the ship if the waters start to look too turbulent. But as the government allows for market factors to have a greater influence in the economy, we can expect a period of increased volatility, which may be triggered by spikes in interbank lending rates and a liquidity squeeze, or by further credit defaults.

Kerry Craig is global market strategist of JP Morgan Asset Management