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Beverly Chandler

Greater China economist quotes Lennon and predicts China recovery


Chi Lo, Senior Economist for Greater China with BNP Paribas quotes John Lennon in his latest comments on the situation in the country.

“Everything will be okay in the end. If it’s not okay, then it’s not the end,” Lennon wrote and Lo argues that the absence of external account problems, excessive bank lending, a property market collapse and capital flight add up to an asset market correction and not a financial crisis.

As the world’s second largest economy and largest trading nation, China bears enormous economic  influence  around  the  world,  and Lo finds that bearish  observers  clearly  think  that  when  China sneezes, the rest of the world may catch a cold.
But, he argues that the facts do not support this gloomy narrative. He believes there are two  kinds  of  financial  crisis, an  external  account  crisis,  which  arises  when  foreign
investors/creditors lose confidence in a country’s economic fundamentals and profligate government, or a banking  crisis,  which  usually  stems  from  the  wholesale  market  funding  an  asset  bubble  that  aggravates  a country’s bank balance-sheet mismatch problem when the bubble bursts.
Lo writes: “To  remedy  an  external  account  crisis,  the  country  concerned  usually  has  to  devalue  its  currency  and restructure  its  foreign  debt.    With a banking  crisis,  the  remedy  typically involves recapitalising the country’s domestic banks to contain systemic panic.  As China has neither a fully convertible capital account nor a fully
floating  exchange  rate,  such  a  closed  system  reduces  the  likelihood  of  a  full-blown  financial  crisis  in  its economy. “
China does not face an external account crisis, he writes.  “Its basic surplus (i.e. current account balance plus net  foreign  direct  investment  inflows)  amounts  to  4 per cent  of  GDP  and  its  foreign  exchange  reserves  amount  to more than 40 per cent of GDP These levels are enough to cover more than two years of imports (compared  to  the  safety  norm  of  three  months-worth  of  imports).    Its  short-term  foreign  debt  is  only  8 per cent  of GDP, despite its rapid accumulation in recent years; total (local and central) government debt is just 52.8 per cent of GDP which is below the danger threshold of 60 per cent.”
Lo argues that China does not face a banking crisis either. “China’s asset bubble has not been funded  by  excessive  bank  lending,  as  seen  by  the  loan-to-deposit  ratio  remaining  well  below  the  0.75 regulatory  cap  when  the  property  and  stock  market  bubbles were inflated.  The banking sector’s balance  sheet  mismatch  has  improved  in  recent  years and  its  average  capital  adequacy  ratio  is  high at over 10 per cent.  The system’s average loan-loss  provision  remains  at  200 per cent of  bad  assets,
despite some drop-off from a peak of 300 per cent and rising non-performing loans.”
And in terms of property, Lo says: “Meanwhile, China’s property market correction has not seen a collapse in property prices like that in  the  US  property  bust  in  2007-08  which  caused  undue  financial  stress  in  the  banking  system.  This  may  likely be a result of a lack of excessive leverage in China’s property bubble and the government’s implicit guarantee policy, which is designed to prevent a loss in public confidence in the banks.”
Lo concludes that any perceived China crisis seems to be stemming from the fear of capital flight by local Chinese.  “In our view, this is unlikely because China’s capital account is still relatively closed, and most Chinese investors can still  get  a  5-6 per cent yield  on  local  wealth  management  products.    They  would  also  have  to  pay  3-4 per cent for currency  conversion  charges  to  take  money  out  of  the country.    The  trade  would be  worthwhile only  if they expect the renminbi to fall by more than 10 per cent, which we believe is unlikely.”
Lo believes that rather than a financial and economic meltdown, China is seeing an overdue correction in its asset market.
“Beijing  did  intervene  heavily  in  the  stock  market  initially,  but  retreated  after  about  two  weeks.  Allowing  the correction  to  take  place  is  part  of  the  process  of  China  further  opening  up  its  financial  system  to  market forces.  The  recent  sell-off  of  Chinese  assets  reflects  the  frictions  from  economic  rebalancing  and liberalisation, rather than being based on the fundamentals of the Chinese economy” Li writes.
“In the coming months if Beijing manages to keep the renminbi stable, if China’s economy starts to stabilise, and if the renminbi is admitted to the International Monetary Fund’s Special Drawing Rights basket, the market will  have  to  admit that China’s economic growth had not crashed, thanks to a stabilising property market and the continued expansion of the service sector that has kept wages, job and consumption growth stable. Those who have sold China short may then wonder why they were involved in a negative carry-trade based on  fundamentals  that  are  not  as  bad  as  they anticipated and expected  catalysts that never  materialised.”
Lo predicts that when they start covering their short positions at a time when the renminbi is under-owned and when China runs the largest trade surplus in the world, Chinese asset prices and the renminbi exchange rate will have to rise.

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