Summary
A renewed COVID outbreak, natural disasters, enhanced regulatory scrutiny and noticeably unsettled financial markets have all contributed to a slowdown in China’s economy. As these indicators have deteriorated, we have recognized the need to monitor the health of China’s economy at a regular frequency, using a comprehensive approach. In that context, we are introducing our China Economy Gauge, a dashboard-style monitor designed to track the evolution of local economic conditions in China as well as potentially offer insight into the direction of monetary policy. As of now, the gauge indicates China’s economy is indeed under pressure. That is consistent with multiple downward revisions we have made to our GDP forecast this year, and underpins our expectation for the People’s Bank of China (PBoC) to again lower its Reserve Requirement Ratio (RRR) before the end of this year.
In addition, we created a China Sensitivity framework in an effort to identify which countries could be vulnerable, both economically and from a financial markets perspective, to a prolonged economic slowdown in China as well as elevated volatility in Chinese financial markets. The combination of export exposure to China as well as statistical analysis gives us a sense for which countries could be most at risk should China experience a “hard landing” type of scenario.
China Economy Gauge Flashing Red
The slowdown of China’s economy over the past few months has been well documented. As a reminder, we have revised our GDP outlook lower multiple times, and as of now, forecast China’s economy to grow 8.2% this year. We have also noted that we see the risks around our GDP forecast as still tilted to the downside, and additional downward revisions to our growth forecast could be forthcoming. A renewed outbreak of COVID cases and subsequent restrictions have weighed on economic prospects and has placed uncertainty over China’s economic outlook, while a severe flood has also put downward pressure on activity lately. On top of virus and natural disaster shocks, Chinese authorities have embarked on a regulatory crackdown targeting a wide array of sectors. President Xi’s push for “common prosperity” has included stringent regulations on China’s technology, education and real estate industries, and given Xi’s commitment to social equity, we would not be surprised if the regulatory clampdown extended to additional sectors over time. And finally, Evergrande, China’s largest property developer and one of the biggest real estate companies in the world, is potentially on the brink of collapse. Assessing the systemic impact of an Evergrande default or bankruptcy is challenging; however, we can say with more confidence that local consumer sentiment would be negatively impacted and foreign investment flow into China could be disrupted amid a disorderly resolution of Evergrande’s debt issues.
This combination of events has resulted in a noticeable decline in economic activity as well as sentiment. Retail sales slowed considerably in August, undershooting consensus expectations by a wide margin. In addition, the manufacturing and non-manufacturing PMIs have also softened over the last few months, with the services PMI currently in contraction territory at its lowest level since the beginning of the COVID crisis in February 2020. Other leading indicators such as industrial production have not been as robust either, while investment and financing conditions have also softened. While we monitor China’s economy closely and update our forecasts frequently, the size and scale of China’s economy arguably warrants a more regular update. In that context, we are introducing the China Economy Gauge, a dashboard-style monitor designed to track the evolution of local economic conditions. Included in the China Economy Gauge are alternative measures of activity and growth that we label as “Economic Growth Proxy.” We also incorporate high frequency indicators to assess the manufacturing and services sectors, as well as China’s trade position and FX reserve adequacy. In addition, our gauge includes monthly indicators of investment and financing conditions. Fixed asset investment is an important indicator of short-term investment, while total social financing and money supply are strong indicators of credit growth and financing conditions. In our view, these indicators should provide good scope into short-term GDP growth as well as the potential direction of PBoC monetary policy.
In short, the more red our dashboard shows, the more downward pressure the local economy is likely coming under. Q2-2021 is when our dashboard starts to flash red for most indicators, especially the external sector and local financing conditions. May is also when data started to surprise to the downside, as the economic surprise index turned negative. A negative economic surprise index number is defined as actual data coming in lower than consensus expectations. The bigger and more frequent the downside surprise is, the more negative the index turns. In Q3-2021, our monitor flashes red for additional indicators, and as August data were released, our economy gauge turned an even darker shade of red. The speed and magnitude of the slowdown also filtered down to PBoC policy. In July, China’s central bank opted to lower the Reserve Requirement Ratio for all banks as economic conditions worsened and the outlook became less clear.
Our dashboard (Figure 1) suggests the short-term outlook for China’s economy is indeed deteriorating, consistent with the multiple downward revisions we have made to our GDP forecast over the past few months. Given the signals our gauge is showing, we believe easier monetary policy could be the next major policy move from the PBoC, and another RRR reduction could be imminent as authorities look to offset some of the deceleration. To that point, we also believe the PBoC will look to lower the Reserve Requirement Ratio (RRR) by 1 percentage point for all banks at least one more time before the end of this year.
China Economy Gauge
Which Countries Are Sensitive to a China Slowdown?
A pronounced slowdown in China’s economy could have wide ranging ripple effects. Given China’s status as the second largest economy in the world, a drop in Chinese growth would likely have negative consequences for global growth prospects. China is also a major trading partner for many emerging market countries. A sharp deceleration in China’s economy would likely result in less demand for foreign products, leaving countries heavily reliant on Chinese demand vulnerable to economic slowdowns in their domestic economies. In addition to export reliance and economic impacts, a sharp China slowdown could have implications for developing country financial markets as well. Should China’s economy come under pressure, we would expect market participants to place depreciation pressure on China’s currency. Given China’s influence within the emerging markets, downward pressure could also build on emerging market currencies more broadly. The same could be said for equity prices as well. A sell-off in Chinese equities as a result of a downturn in China’s economy could spread across the emerging markets and weigh on local equity prices within individual emerging market countries.
As a result, we have created the China Sensitivity table to assess which countries could be most vulnerable, both economically and from a financial markets perspective, to China’s deceleration. As mentioned, economies with an elevated reliance on Chinese demand could be particularly sensitive to a slowdown in China. In our table, we label countries with exports to China worth over 6% of GDP as “Highly Sensitive” and highlight these countries in red under the “Exports to China” column. According to our analysis, and within our sample of countries, Singapore, South Korea, Chile, Thailand and Peru are most sensitive given their high level of export exposure to China. Countries highlighted in orange under the same column have export exposure to China worth between 2% and 6% of GDP and we identify these economies as “Moderately Sensitive”, while countries in green have exports to China worth less than 2% of GDP and, in our view, have little direct economic sensitivity to a sustained downturn in the Chinese economy. Our analysis suggests economies such as Poland, Mexico, Colombia, India, Turkey and Israel could be insulated from a prolonged China deceleration.
Our analysis indicates a sharp and sustained economic slowdown in China could have more of an impact within the financial markets. In order to gauge the currency market impact, we analyzed the relationship of each emerging market currency in our sample in response to the Chinese renminbi using statistical regression analysis. We estimate that regression from the beginning of 2016 to today of weekly percentage changes in various emerging market currencies versus weekly percentage changes in the offshore Chinese renminbi (CNH). The coefficient or beta from these regressions indicate how sensitive these currencies are to moves in CNY. For example, the South African rand’s beta of +1.54 indicates that ZAR and CNH tend to move in the same direction, and that a 1% depreciation in the offshore renminbi tends to result in the South African rand weakening by around 1.5%. Our sensitivity table assumes that currencies with a beta of +0.90 to CNH are highly sensitive and we highlight these currencies in red under the “Currency Beta” column. Highly sensitive currencies include the South African rand, Brazilian real, Russian ruble, Polish zloty as well as the Mexican and Colombian pesos. We also assume currencies with a beta between +0.40 and +0.90 are moderately sensitive and highlight these currencies in orange on our table, while currencies with a beta to CNH below +0.40 suggest little sensitivity and are labeled as green in the Currency Beta column.
We employ a similar methodology to gauge local equity market impacts as well. As far as the equity market response, we also analyzed the relationship of the major equity index of each emerging market country in our sample in response to China’s Shanghai Stock Exchange Composite equity index again using statistical analysis. For example, in the case of South Korea, the country’s Korea Composite Stock Price Index (KOSPI) has a beta of +0.40. A positive beta indicates the KOSPI and the Shanghai Composite tend to move in the same direction, and a 1% drop in Chinese equities could result in a 0.4% fall in local Korean equities. We assume a beta of above +0.30 is highly sensitive to Chinese equities and we highlight these countries in red under the “Equities Beta” column. Under this assumption, our framework suggests local equity markets in Singapore, South Africa and South Korea are highly sensitive to a sell-off in Chinese equities. A beta between 0.20 and 0.30 suggests local equities are moderately sensitive to Chinese equities, while a beta below 0.20 may not be as sensitive as the countries highlighted in green. According to our analysis, equity markets in Mexico, Colombia, Turkey and Israel may not be sensitive to an outsized sell-off in Chinese equities.
Combining these three indicators gives some sense of which countries could be most, or least, sensitive to China and the economic slowdown that is currently underway. Countries highlighted in red under the “Overall China Sensitivity” column are most sensitive and could experience relatively larger economic and financial market impacts from China’s deceleration and regulatory crackdown. Countries highlighted in green should see a relatively small economic impact, while their respective currencies and equity markets should experience limited volatility. Our analysis indicates that countries heavily reliant on exports, high commodity prices, and which are tightly integrated into China’s financial system should come under the most pressure. In that sense, Singapore and South Korea are often cited as bellwethers for the global economy, given their status as large exporting countries. Our analysis identifies Singapore and South Korea as particularly vulnerable to China. In addition, countries such as South Africa, Brazil, Chile and Russia are heavily reliant on high commodity prices, while each country is also fairly dependent on exporting commodities directly to China. An economic slowdown in China would likely result in less demand for commodities and could weigh on each economy. In addition, each of these currencies are highly correlated to commodity prices, while commodity-related companies make up a large component of each respective equity index. As a result, each currency as well as local equity markets could come under pressure.
On the other hand, countries less reliant on exports with more diversified economies could be less sensitive. In that sense, our framework suggests the Indian economy may not be sensitive to a slowdown in Chinese demand. India is also a large commodity importer and could also be a beneficiary if China were to pull back on demand for a broad range of commodities. In addition, the Reserve Bank of India (RBI) has a large stockpile of FX reserves that it regularly deploys to limit volatility in the rupee. RBI FX intervention is a key component to the rupee’s low sensitivity to the offshore renminbi. Turkey and Israel also do not export a significant amount of product to China and are also commodity importers that could stand to benefit economically from a China slowdown. The Turkish lira tends to be one of the more volatile emerging market currencies; however, local equity markets do not respond much to moves in Chinese equities. In Israel’s case, the Israeli economy is very diversified, while the Tel-Aviv equity index and Israeli shekel are not very volatile and their betas would indicate the currency and local equities do not react much to large moves in Chinese equity markets.
China Sensitivity 
