At some point, China is headed for a major crash and it will remain a source of volatility for global markets in the meantime, argues Pictet in a blunt warning.

There has been a great deal – to put it mildly – of commentary about China’s economic position, its recent market falls, as well as its continuing ambitions to make the renminbi a global reserve currency. In this article, Christophe Donay, who is chief strategist for Pictet Wealth Management, predicts that China cannot indefinitely delay the reality of a crash, however unpalatable that prospect may be. This makes for sobering reading in different parts of the world. As at the time of writing, the UK is playing host to China's president, Xi Jinping. The impact of any sharp decline in Chinese GDP or a further slide in its markets will not be confined to Asia. The views of the author are not necessarily shared by the editors of this publication but they are pleased to share these views and invite readers to respond.

Markets globally continue to be buffeted by concerns about slowing growth in China. The country is passing through a drawn-out transition period to a new economic model, and we doubt that the shift will be completed without a major shock. Conditions are not yet ripe for this - we think the authorities will succeed in supporting economic growth at close to 6.5 per cent this year and next. But as the economy’s imbalances become increasingly unmanageable we expect, eventually, a Minsky moment for China - a sudden, sharp collapse of asset prices. In the meantime, China is going to remain a source of volatility for global markets.

China: a difficult period of transition
Recent developments in China need to be seen in the context of long-term economic trends. Between 1990 and 2020 China’s economy will have passed through three phases. The first, from 1990 to roughly 2006, was China’s "emerging" period: joining the capitalist club and integrating into the global economy. This phase was characterised by astonishing rates of real GDP growth, at 12-13 per cent annually.

The final phase will be "maturity", and should begin by 2020. Real GDP growth will settle at around 5 per cent annually as China becomes wealthier and easy catch-up gains are exhausted. The interim phase, which began in around 2006 and likely has a few years left to run, is one of "transition". It is proving to be a drawn-out shift - set to last over a decade - for two reasons. 

First, it involves a change of economic model, from investment- and export-led growth to growth based on private consumption. An economy that is now the world’s second largest cannot continue to rely on exports to drive its growth, and excessively high investment becomes increasingly wasteful.

Second, China’s transition was delayed and complicated by the US subprime crisis. Faced with a collapse of external demand early in their economic rebalancing, the Chinese authorities opted to unleash a massive economic stimulus. They boosted government spending, including a RMB4 trillion ($586 billion) stimulus programme in 2008-09, and ramped up credit - lending to firms and households is at 207 per cent, up sharply from 125 per cent of GDP in 2008. This succeeded in maintaining growth, but at the cost of creating sizeable imbalances.

Imbalances have worsened
The challenge for China is now to complete its transition without an economic shock (recession) or financial shock (market crash). The big question is whether the Chinese authorities can manage this. In our view, they will probably fail, for two reasons.
First, China’s growth is still excessively reliant on investment. Private consumption, although gradually rising as a ratio to GDP - reversing a long-term declining trend - still accounts for only around 38 per cent of the economy, compared with around 70 per cent in developed economies. Investment’s weight in the economy appears to have peaked, but it is still around 46 per cent of GDP, whereas the experience of other emerging economies suggests a sustainable rate of around 20-25 per cent.

Second, growth has been driven in recent years by pumping up credit, which has substantially exceeded nominal GDP growth for several years - in August it was at 14.7 per cent year-on-year. Such periods of rapid credit growth tend to create dangerous instability somewhere in the economy. Concerns in China include, aside from the stock market, the property market and the finances of local governments and the non-bank financial sector. 

A Minsky moment looks likely, eventually
These imbalances point towards an eventual Minsky moment in China - a sudden, sharp collapse of asset prices. This might be triggered by a sharp economic slowdown, a tightening of credit, a shock to equity markets, or even by the collapse of a major company viewed as a bellwether for the economy. 

The timing of such a collapse is impossible to predict, but conditions do not yet seem ripe for it. Government debt is just 40 per cent of GDP (compared to typically around 100 per cent of GDP in developed economies), and China still has the world’s largest international reserves to fall back on, at $3.6 trillion (equivalent to around 35 per cent of GDP). The authorities can therefore continue for now to support growth by directed spending and lending through the state budget, local governments, state-owned enterprises and banks, and through maintaining attractive financing costs - the People's Bank of China cut interest rates again in August.

The credit cycle still has space to run, and we expect GDP growth in China of close to 6.5 per cent this year and next.

However, although the authorities have the resources to avoid a financial crash for now, they will not succeed in doing so indefinitely. First, their ability successfully to manage the economy has been called into question by their indecisive response to recent turmoil - initially supporting the equity market only then to let it slide. Second, continued market liberalisation - a necessary element of economic rebalancing - will further weaken their ability to dictate the market. Finally, their methods to support growth during the transition phase by pump-priming the economy will only exacerbate imbalances and raise the likelihood of an eventual crash.