US equities are cheerily unconcerned about the possibility of the Chinese economy taking a serious hit as a result of coronavirus outbreak. But in the last week, several overlapping stories in widely-read mainstream news outlets have taken issue with the consensus, and argue that China downside scenarios are both more probable and more serious than the mainstream view.
In fairness, the more sober-minded bond market is rattled, and commodities, which are heavily exposed to Chinese activity, are already wobbly. So it isn’t as if investors broadly are asleep at the wheel. From Ambrose Evans-Pritchard at the Telegraph today (we’ll be turning soon to his last week clarion call on China coronavirus risk, and the kindred assessments by other analysts):
Safe-haven flight into the Swiss franc, the Japanese yen, and the dollar suggests that some large funds are battening down the hatches. The Australian dollar, a proxy for risk appetite, is plumbing depths last seen during the Lehman crisis.
The US dollar index (DXY) has been rising for several weeks and is not far short of 17-year highs. This creates a self-fulfilling effect of world-wide tightening. It drains global liquidity and squeezes borrowers with $12 trillion of dollar liabilities on the offshore funding markets in Asia and Europe….
“We’re seeing all these signs of recessionary ‘risk-off’ behaviour. Something has to give here,” said Lars Christensen from Markets and Money Advisory….
Few analysts have begun to ‘price’ the implication of a full-blown COVID-19 pandemic across the world…
A pandemic is no longer a scientific tail-risk. It is fast becoming the central risk…We should have a clear idea whether or not the spread is unstoppable within three weeks.
The US Defence Department’s Joint Staff has already activated its pandemic plan, ordering all services to brace for “widespread outbreaks” of the virus, according to Military Times.
We’ll focus on China, since the immediate economic concern is how the progress of the disease and efforts to manage it hurt their citizens and companies, which affects the West directly (supply chain disruption, loss of critical supplies, damage to companies that do a lot of business in and with China) and indirectly (the hit to global demand).
So forgive me a US aside before returning to the China front. Even though the plural of anecdote is not data, I see signs of concern even in the currently low-risk US (my scenario for how things might get troublesome here is that coronavirus winters in the global South, particularly Africa and Australia, and is primed to become US health risk during the 2020-2021 flu season). For instance, a friend in Dallas supplied me with several products, including a hand sanitizer used in operating theaters that supposedly kills nasties for five hours. Interestingly, she didn’t view coronavirus as a current risk but felt it was important to establish protective habits and routines well in advance of a potential threat. This suggests that not only will Americans stay well away from China for some time, but some may already be considering foregoing travel not just to Asia, but potentially even non-essential US trips.
Back to the main event. The fact that gas prices at the pump in low-fuel tax states are increasingly at or below $2.00 a gallon ought to be a wake-up call that serious deflationary forces are at work, even if cheaper fillups provide a short-term boost to consumers.
The apparent reason for continued peppy stock markets is that too many investors are mistakenly comparing the coronavirus to China’s 2002-2003 SARS outbreak. There are plenty of reasons why this is wrong-headed. SARS was easier to contain because China was much poorer then, so Chinese traveled less. Its high fatality rate (nearly 10%) also likely resulted in citizens taking social distancing measures of their own, in addition to official ones. Experts in China also claim the government was faster to address the contagion then. One result was the successful identification of “supertransmitters,” which was a considerable aid in containment.
Economically, China was vastly smaller in global GDP terms. It had just been admitted to the WTO and thus was only beginning to become integrated into global supply chains. And the timing of SARS worked out to be better too. Its major outbreak took place later in the year, as opposed to during a peak travel time.
And the coronavirus has already surpassed SARS in number of deaths and number of confirmed cases.
China has been fragile for some time. It has managed to avoid a downturn but to a significant degree, that has occurred by virtue of increasing risk, particularly private sector leverage. That might not be such a cause for concern if the additional borrowing were going into productive activities. But China bears have been pointing out for years how borrowing is producing less and less incremental GDP growth, as evidenced by often shoddily built ghost cities. China has been trying to curtail bank lending, but the government has engaged in stop and go tightening, relenting and loosening liquidity when growth flags.
China has already taken damage from the swine flu, with more costly pork hitting consumer budgets, and from the Trump trade wars, where many small and mid-sized Chinese companies reporting considerable delays in getting paid, forcing them to belt-tighten to conserve cash.
A South China Morning Post columnist, Cary Huang, has set forth a worst-case coronavirus forecast, which includes widespread bank failures. He argues that the fact that China has more of a consumer economy than it did nearly two decades ago during SARS makes the economy more vulnerable to hits to domestic demand. Some of his other important points:
The country has 288 million migrant workers, who account for about a third of China’s labour force. Many who travelled to rural homes for the holidays will be either unable or unwilling to return to work in the cities….
Many small manufacturers fear foreign customers will shift orders to other countries due to disruptions in production and delivery. In a survey of 995 SMEs by academics from Tsinghua and Peking universities, 85 per cent said they would be unable to survive for more than three months under the current conditions. If the disruption goes on long enough, it could trigger a wave of bankruptcy among SMEs, which contribute more than 60 per cent of China’s GDP, 70 per cent of its patents and account for 80 per cent of jobs nationwide.
Finally, the epidemic will weigh on banks in the form of non-performing loans, adding risk to the banking system and pressure to the country’s towering debt pile…the risk of default on the country’s 99.1 trillion yuan of outstanding onshore bonds is increasing. Corporate bond defaults already hit a record high last year amid an economic slowdown. The lower revenue and land sales income for local governments will in turn hit local government financing vehicles. The disruption will weigh on the capacity of some companies and individuals to repay loans, pushing up delinquency rates. Financially weak SMEs could face additional funding pressure as they are exposed to refinancing risk….
Thus, the worst-case scenario cannot be ruled out. Massive financial collapse, an exodus of foreign companies and large-scale bankruptcies all loom on the horizon if this epidemic cannot be contained soon.
Last week, Ambrose Evans-Pritchard may have outdone himself in terms of apocalyptic-seeming framing, even though his argument is, as always, cogent. He believes China will find the economic cost of continuing to try to contain the coronavirus to be too high, and they will relent and let the virus spread faster globally. The paranoid would argue that the improvement in China’s reported new infection numbers might be a PR artifact to allow China to back off, irrespective of bona fide facts on the ground.
Of course, one can counter AEP by pointing out that even if China lets up on formal restrictions, many if not most Chinese will continue to isolate themselves as much as possible. While officials might be able to require employees outside Hubei to return to work, they can’t require them to go to restaurants and shops. And it seems unlikely that foreigners, particularly tourists, will be willing to visit China until they are confident the infection has been vanquished. How much good would it do to get factories back to normal if, say, shipping company workers and air carriers’ crews continue to be leery of China as a port of call?
Where do we now stand? Regions making up two-thirds of Chinese GDP have been closed since late January. It appears that few people have actually returned to work this week…
Another is property sales in 30 big cities released every day (amazingly). Sales have collapsed to zero and have yet to show a flicker of life…..
Property is a slow-burn issue compared to ruptured manufacturing supply chains, but by March it will start to bite for developers with dollar debts on Hong Kong’s funding market…
Some 25 provinces and municipalities were supposed to go back to work this week but this clashed head on with virus control measures. Companies may not reopen plants unless they can track the exact movements and medical data of each worker, and comply with a 14-day quarantine period where necessary…
The Guangzhou authorities have ordered plants to remain closed until early March in large parts of the city with warnings of ferocious penalties. Apple supplier Foxconn has yet to restart its core iPhone plants in Zhengzhou and Shenzhen. Just 10pc of its workers have turned up. Caixin reports that Foxconn may wait until March before restarting.
Meanwhile the near complete shutdown of Shanghai’s manufacturing hub in Songjiang belied early claims that 70pc of plants were going back to work…
Global angst is for now largely focussed on the car industry, commodities, and shipping. Hyundai, Kia, and Ssangyong have had to shut their car plants in Korea for lack of components. Nissan has closed two assembly lines in Japan. This will spread to Europe within a couple of weeks if the crisis drags on….
This from Richard Meade at Lloyd’s List: “This health emergency has paralysed ports, it has disrupted schedules across all sectors, led to serious challenges for crew management, and prompted a round of container services to be withdrawn, with lines now forecasting issues well into the second quarter of the year. It has thrown the global gas market into turmoil,” he said.
Mind you, the original has more evidence of distress and more detail.
Finally, Business Insider has a new piece in which Linette Lopez tries to grab readers by the lapels and shake some sense into them. The angle of this piece is that investors expect China to make a fast recovery from any coronavirus hit, a view Lopez depicts as delusional. She points out that liquidity had dried up in the banking sector at the end of 2018 (and the US-China trade row was not a culprit). In May, for the first time in decades, the government bailed out some sick banks. Next came a panic, with inter-bank lending freezing up. Officials knocked heads together but also told banks to cut the value of their investments in each other. That’s a fast way to show that banks aren’t as healthy as they pretended. But those now-exposed-as-sickly capital bases means those banks need to work on retaining more earnings and maybe even shrink their balance sheets. Those are not conducive to a lot of new lending.
But worse, in a case of massive mixed signals, these banks are likely to be pressured to not write down loans that go bad thanks to coronavirus. This is the Japan zombification playbook. From Lopez:
Because of the coronavirus, this weakened banking system — less than one year out from being on a bit of a brink — will now have to forgive loans for companies large and small and continue financing local governments dealing with the fallout from stagnating economies and the effort to fight the coronavirus. S&P research estimated that if this crisis is prolonged, bad debt in the banking system could increase from 2% at the end of last year to over 6%.
In this environment, some kind of liquidity event could be even more disruptive than it was in the summer.
“Banks will all be more sensitive to their exposure to each other. And they don’t really know each other’s risk,” Dinny McMahon, the author of “China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans and the End of the Chinese Miracle,” told Business Insider. “If there was a liquidity event, you might see a flight to safety very quickly, and how the banks define safety may be a bit more severe than it was last year.”
And then, of course, even if the banks could forgive loans and ease credit conditions, that would only do so much. Some businesses simply may not be creditworthy after this economic shock….
China’s other financial-system struggle over the past year was ensuring that private-sector companies, mostly small and medium-size enterprises (SMEs), were getting adequate funding. A lot of these companies used to get financing from China’s shadow-banking system, so when authorities cracked down on that in 2017 and 2018, they got squeezed…
That is why China announced last week measures to support SMEs that have nothing to do with the banks, including asking local governments to waive taxes and administrative fees.
There is one additional wild card: the stability of Xi Jinping’s government. Even though Xi has centralized power, he has also presided over the swine flu, the Trump trade war, and now coronavirus. This Project Syndicate article highlights the fractures in Xi’s fortress (hat tip UserFriendly):
Normally, a single epidemic, even if mishandled, would not break the Chinese regime. Over the past four decades, the CPC has weathered numerous crises, from the 1989 Tiananmen tragedy and the 2002-03 SARS epidemic to the 2008 global financial crisis…
This time is different. Since coming to power in 2012, Xi has tightened political control at home and projected superpower ambitions abroad. These policies have unnerved Chinese private investors, alarmed Western powers, and sharpened tensions with the United States, all of which have contributed to a broader economic slowdown.
The COVID-19 outbreak has added an additional source of stress and unpredictability to the regime’s mounting challenges. As the epidemic persists, China will struggle to reopen for business, bringing even stiffer economic headwinds as small- and medium-size enterprises fail, workers lose jobs, and inflation picks up. While the Chinese leadership is highly adept at solving one crisis at a time, it has rarely had to confront so many near-existential crises at once..Indeed, cracks are already appearing in Xi’s supreme leadership.
For example, at the peak of the public outrage over the government’s initial cover-up of the outbreak, Xi disappeared from public view. After his meeting with the director-general of the World Health Organization, Tedros Adhanom Ghebreyesus, on January 28, he didn’t resurface until his state meeting with Cambodian Prime Minister Hun Sen on February 5. For a leader who normally dominates China’s news cycle every day, Xi’s absence amid a national panic was conspicuous, and led some Chinese observers to speculate that his grip on power may be in peril.
For instance, the government was not able to contain the outrage over the death of coronavirus whistleblower Dr. Li Wenliang, who died earlier this month after being arrested and detained by local police for sounding early warnings. From the Guardian:
On Friday, China’s social media was awash with posts expressing immense anger and grief.
Li’s death became the top-read topic on China’s microblogging site Weibo overnight on Friday, with more than 1.5bn views, and was also heavily discussed in private WeChat messaging groups, where people expressed outrage and sadness.
Even blog posts from state media outlets mourned his death and issued veiled attacks on the Wuhan authorities who censured him…
Fearing that the uproar over Li’s death could spill over onto the streets, the authorities quickly deleted posts calling for action. A post forwarded on Wechat but now deleted said: “I hope one day we can stand on the street holding Li Wenliang’s picture….
The outpouring of grief quickly turned into demands for freedom of speech, but those posts were swiftly censored by China’s cyber police. The trending topic “#we want freedom of speech” had nearly 2m views on Weibo by 5am local time, but was later deleted. The phrase “#Wuhan government owes Dr Li Wenliang an apology” also attracted tens of thousands of views before it too disappeared.
My Chinese friends have confirmed this – it’s all over Chinese social media and the government is struggling to control the message – even official Party outlets are expressing outrage. There is very real anger over his death – this could be a real game changer for the government.
I thus may be reading too much into a Financial Times report today, that Xi knew of the coronavirus outbreak weeks before his earlier claims. To put it mildly, that revelation does not strengthen his position. From the Financial Times:
Chinese president Xi Jinping issued orders to contain the deadly coronavirus outbreak almost two weeks earlier than previously thought, according to an account that appears to contradict the narrative that local officials were to blame for allowing the epidemic to spiral.
The official Communist party magazine Qiushi’s account over the weekend says Mr Xi met the party’s politburo standing committee, China’s most powerful decision making body, and gave instructions on the virus response on January 7, 13 days before the public was warned about the outbreak’s severity.
Previous state media accounts appeared to date Mr Xi’s earliest direct involvement to a January 20 statement. The magazine instead said he was aware and in charge of the response to the virus almost two weeks earlier, potentially implicating Mr Xi in the bungled early response to the outbreak that contributed to its rapid spread.
This means Xi was in charge more than 10 days before the January 18 official banquet in Wuhan, which was a huge affair. Per an earlier Financial Times account:
Long tables in 10 locations were laid out with a total of 13,986 dishes, some bearing patriotic names such as Motherland in My Heart (cucumber and ham), and One Belt One Road (vegetable salad). The platters were prepared by members of some 40,000 families, according to media reports, with many of them showing up to eat the food and smile for the cameras.
Recall that Xi’s term does not end until 2022 and he eliminated constitutional term limits. However, there are ways from him to have his power curbed short of a vicious power struggle. For instance, the Project Syndicate story points out that the formerly all-powerful Mao was pushed into early retirement as a result of his disastrous “Great Leap Forward” even though he remained titular leader. It’s plausible that Xi might quietly cede power, perhaps a lot of power, to stay at the helm and hope for better days.