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There is a belief that any adverse effects on the real economy, as a result of the equity capitulation, will show up in Q3 numbers, not Q2.
If anything, the bull market for much of the first half of this year would boost overall growth through a higher GDP contribution from financial services. This seems to be the case as the release of the Q2 GDP reading on Wednesday, 15 July, shown.
The Chinese economy grew faster than expected in the second quarter, at 7% y/y, while many were looking for a reading below 7%.
Much of the growth activity was attributed to Beijing’s fiscal-monetary easing. While this may be true, we have to bear in mind that the stronger growth is likely to be riding on the back of a larger contribution from the financial services, given the sustained record levels of stock market turnover during the period.
If you recall from Q1, financial services contributed around 10% to nominal GDP, as the bull run in Chinese equities was unabated. That said, the extreme measures taken by the financial sector in early July to arrest the huge slide in the stock market, may translate to a smaller contribution from financial services in Q3.
To be sure, market volatility may have an impact on the real economy through several channels, including negative wealth effects on consumption, influence on wider financial and banking sectors, spill-over to the property market, issues of market confidence, and reputational risks. However, most of these indirect effects are likely to be fairly minimal, as the bulk of household financial assets is still in bank deposits, with only around 20% in equities.
Furthermore, only 7% of urban middle households uses margin trading although one-third has stock accounts, according to Goldman Sachs. This suggests that further unwinding of margin debt is likely to be concentrated in a small proportion of households.
Soft landing dynamics
The Chinese economy showed signs of a slowdown in early 2015, after experiencing the sixth consecutive year of GDP deceleration in 2014.
The slowdown is widely interpreted as structural in nature and few believe a return of the era with double-digit growth rates is possible. However, if the problems confronting China is structural rather than cyclical, the implication is that expansionary policies would be less effective in mitigating the slowdown. So why is Beijing still pushing out looser monetary policies and stepping up infrastructure investment?
In China, policymakers have often tackled slower growth with countercyclical stimulus measures. It serves to presume that if the slowdown is cyclical in nature, such policies would be effective. A case in point was the country’s policy response to the global financial crisis back in 2008-2009 where a massive stimulus programme was unleashed.
This succeeded in averting an economic collapse which could have been brought about by the effects of a negative external shock. While this came at the expense of shelving plans to rebalance the economy towards consumption-driven instead of investment-led, the adverse conditions at that time warranted a transitory shift in priorities.
Much of the slowdown in recent years increasingly seems to be structural in nature, which suggests that a counter-cyclical stimulus is unlikely to be successful. However, there is another school of thought which put forth that structural reforms could actually moderate China’s slowdown, or even reverse it for a time.
Regardless, we are seeing signs of stabilisation in the Chinese economy. Liquidity and credit conditions are showing improvements, which point towards the positive impact of monetary policy easing. Real demand for credit seems to be on the rise, implying firmer domestic demand.
Meanwhile, trade growth rebounded in June, which hints at better external demand as well as a pick-up in domestic consumption. This was corroborated by an acceleration in industrial production and retail sales in June. Of course, continued stimulus measures from the government will also be supportive of real economic growth.
Equity investors unimpressed
Interestingly, equity markets did not respond positively to the Q2 GDP numbers, despite beating market estimates. This suggests that investors are not convinced that we have seen an end to slowing growth.
I also get a sense that the recent moves from the government to shore up the stock market has dulled market responsiveness. Ever since the Chinese regulator implemented hard-hitting measures on all fronts, volatility in the stock markets has fallen.
Overall, it may very well be that only a visible improvement in the economy and solid corporate earnings would restore investor confidence in the stock markets. Clearly, this is going to take time. For the moment, I see Chinese equities entering a period of consolidation in the coming months as market participants adjust to the slew of measures as well as the imminent withdrawal of such measures.