Growing uncertainty about China’s economic and financial trajectories is raising the risk premium on global stocks and on China-related plays in particular. This, along with weakening growth/contracting corporate profits in many parts of the world, will continue to weigh on global equities in general and especially EM risk assets.
China is enduring enormous deflationary pressures. Producer prices for final products in general and export prices in particular are deflating, and volume growth is either weak or contracting. In turn, Chinese companies’ debt-to-GDP ratio has skyrocketed since 2009. As such, Chinese companies’ debt burdens in real (inflation-adjusted) terms are rising as an increasing amount of sales volume is required to service the same amount of nominal debt.
China can partially export debt deflation to the rest of the world via depreciating its currency; depreciation helps the pricing power of exporters and companies that can engage in import substitution. But there is much uncertainty about China’s willingness/ability to use its currency to mitigate deflation. And in any case, it will not insulate China from the pain entirely because depreciation will not help the most leveraged parts of China’s corporate sector, namely, property developers, industrials and materials companies.
Nonetheless, the critical question for investors is whether Chinese policymakers can achieve gradual currency depreciation in a way that domestic interest rates do not rise. This is possible, but not guaranteed.
Rising uncertainty about the path of China’s exchange rate, interest rates and capital flows, as well as the widening range of potential outcomes for mainland growth warrant a higher risk premium on global assets, particularly Chinese growth-related assets.