Market and risk analysis

We've long been sceptical about the Chinese economy’s potential and our below-consensus forecasts for growth reflects these doubts. Amid the chaos now erupting in China, one thing is absolutely clear – the Chinese economy must transition towards a more Western-style demand-driven system as it can no longer rely on investment-fuelled growth.

The return on investment in China has quite simply declined too much and more and more debt, both private and public, is needed to keep growth close to the official target. Our primary concern about the Chinese economy is that this rebalancing towards a more consumption-driven economy is happening too slowly.

While this means less pain in the short term, as the economy can rely to a greater extent on investment, it pushes the day of reckoning into the future while the underlying problem just grows and grows.

The recent central bank interventions – the Peoples Bank of China has cut the reserve requirement ratio for commercial banks if they meet some lending standards and it has cut the benchmark interest rate by 25 basis points – seem erratic considering the steady economic figures of late. This is particularly odd given the worries about debt-fuelled investments into the stock market.

The consequence of these debt-fuelled investments into a ballooning stock market is now being felt in a very dramatic fashion. That is not only in China where millions of investors are now desperately trying to minimise losses by getting out of stocks.

This selling, which turned into a stampede following the government's initial failure to intervene at the weekend, has in just three weeks resulted in a 33% slide in the Shanghai Stock Exchange Index.

Shanghai Stock Exchange Index down 1/3 in just three weeks [Source: Bloomberg]

With more than 80 million Chinese investors now feeling the immediate impact of this dramatic correction, the implications for the wider world are clarifying. Greece is a slow burn problem for the European Union where the central issue is the risk of contagion, i.e. that Greece serves as a model for an eventual exit of other peripheral countries with perhaps Italy as the next shakiest member though Spain is the first to have parliamentary elections in December.

The China risks are a bit more upfront and a clear and present danger for Australia and other economies which are leveraged to commodity exports to China. So any financial stability risks in China could be felt far more rapidly, even on top of what we have already seen in terms of falling commodity prices.

Iron ore, which is particularly dependent on Chinese growth, has plunged 10% so far today – its lowest level since 2009 and possibly the biggest one-day fall in recent history. Over the course of the past week it has shed 25%.

Aussie dollar under pressure from sliding commodity prices [Source: Saxo Bank]

Apart from regional stock markets taking the brunt of the weakness in China, the commodity sector has also been hit hard. The Bloomberg commodity index which tracks 22 raw materials, is down 7% so far this year and during the last three days it has lost 4.2%, the most since 2011.

Crude oil, which is already hamstrung by a global supply glut and Saudi Arabia's effort to drive US shale producers out of business, yesterday saw the biggest drop in a single session in five months.

In fact, oil is being pressured on multiple fronts, and China's equity wobble, the prospect of Iran's re-entry to the market and low liquidity all add up to an extremely fraught environment. Oil needs to establish a new range and we would see the WTI crude low around $50/barrel with the upside capped at $58/b.

Commodity Performance [Source: Bloomberg and Saxo Bank]

Returning to China, we have seen economic data, including timely survey data like PMI, steadying after some weakness in early 2015, and the actions of the PBoC look very much like a response to the weakness in the equity markets. And so far the PBoC has been unsuccessful in this endeavour – to put it mildly.

This leads us to expect that more attempts will be made to stop this rout before it turns from being a financial issue to becoming a political problem for the rulers in Beijing.

Author:

Ole Sloth Hansen is a specialist in all traded Futures, with over 20 years’ experience both on the buy and sell side. Hansen joined Saxo Bank in 2008 and is today Head of Commodity Strategy focusing on a diversified range of products from fixed income to commodities. He previously worked for 15 years in London, most recently for a multi-asset Futures and Forex Hedge fund, where he was in charge of the trade execution team.