Policy risks to watch after a year of living dangerously

Vehicles clog a main highway during a sixth straight day of severe pollution in Beijing

Economic policy missteps loomed large over China’s economy this year, ranging from a controversial stock market bailout, to a yuan devaluation that roiled global markets to a financing crunch for local governments triggered by fiscal reforms that had to be eased.
Next year may be no different. “Policy continues to be one of the biggest risks in 2016,” said Ding Shuang, chief China economist at Standard Chartered Plc in Hong Kong. “The economy is becoming more difficult to manage so there could be a mistake. The good thing is policy makers tend to be very responsive so the chances of them making a big mistake and sticking to it are small.”
For the year ahead, economists see the risks of more policy-induced turbulence in areas that include the removal of capital controls, overly zealous policies to rein in debt, and a steep depreciation of the yuan. While such outcomes aren’t part of baseline forecasts, the following are areas that could fuel more policy-triggered turbulence in 2016.
After roiling global markets with an unexpected August devaluation, policy makers have since stressed an intention to maintain a stable yuan. Still, Zhu Haibin, chief China economist at JPMorgan Chase & Co. in Hong Kong, says the exchange rate appears to be unsustainable. He estimates it is still overvalued by 5 percent to 10 percent.
One of the biggest risks next year is a sharp depreciation of the yuan, and that’s “close to certain” if the dollar keeps strengthening, says Alicia Garcia Herrero, chief Asia Pacific economist at Natixis SA in Hong Kong.
“The problem will be more for the rest of the world than China,” she said. “It would lead to a round of depreciations in the region.”
While policy makers will strive to avoid “a Lehman moment,” there’s always the risk they underestimate the market reaction to a corporate default, just as they did the reaction to the exchange rate adjustment, says David Loevinger, a former China specialist at the U.S. Treasury and now an analyst at fund manager TCW Group Inc. in Los Angeles.
Chinese non-bank borrowers held an estimated USD1.2 trillion of dollar debt in mid-2015 and the combination of moderating Chinese growth, excess capacity in rust-belt industries, rising dollar yields and potential further dollar appreciation against the yuan all create risks of further stress for corporate borrowers, says Rajiv Biswas, the Asia-Pacific chief economist at IHS Global Insight in Singapore.
That “could trigger an increasing number of corporate debt defaults in 2016,” he says.
Corporate debt in yuan as a share of total economic output has surged since the global financial crisis to 161 percent of gross domestic product as of the end of last year, up from 102 percent as of the end of 2008, data compiled by Bloomberg Intelligence show.
A zealous attempt to rein in local government investment early in the year contributed to the weakest quarterly growth since the 2009 global recession in the third quarter. Officials backed off, reopening a door to bank funding for projects even if borrowers couldn’t meet payments.
While the government will try to reduce the debt load in 2016, it’s a difficult process and so “we can’t rule out the possibility of some sort of market turmoil,” said Zhou Hao, an economist at Commerzbank AG in Singapore.
Buoyed by the yuan’s new status as a reserve currency in the IMF’s Special Drawing Right basket, the top policy surprise could be the complete removal of capital controls abroad for individual investors, says James Laurenceson, deputy director of the Australia-China Relations Institute at the University of Technology in Sydney.
If “capital outflows accelerate as Chinese savers diversify away from domestic assets, the test then becomes what the authorities do with the exchange rate,” said Laurenceson. “Hopefully they let it depreciate and it starts to act as a shock absorber for the real economy. The big risk is that they go for a more open capital account while trying to keep the exchange rate stable, a recipe for disaster.”
With bouts of “airpocalypse” blackening Beijing’s skies, the risk of worsening pollution and growth-reducing policies such as factory closures to combat it can’t be discounted.
And with the anti-corruption crackdown looming over provincial authorities’ decision making processes, there’s an ongoing risk of policy paralysis.
“The biggest political risk, or uncertainty, is the anti-corruption campaign,” said Daili Wang, a Singapore-based economist at Roubini Global Economics LLC. “This has heavily weighed on local government’s willingness to engage in economic activities, and no one knows how far it will go.”
Then there’s the kind of unknown-unknowns that used to keep Donald Rumsfeld awake at night – risks so risky we can’t even identify them.
While it’s human nature to worry about potential problems, risk is a two-way street. There’s always the chance the China bulls have it right, and economic growth is set to strengthen once more as President Xi Jinping’s reform program slices through overcapacity, boosts productivity and leads to more innovation-fueled expansion.
“One surprise could be that the consensus is wrong and investor sentiment turns around because they realize that maybe this is as bad as it gets,” says Loevinger. “Investors realize that maybe China’s hard landing has already occurred with the nominal growth of manufacturing and construction falling from 20 percent to nothing in four years, and yet it was still able to crank out modest growth.”
The world may start to look better too, with economists forecasting a revival in export growth next year.
All risks aside, it’s a safe bet that China will play a key role in determining global economic fortunes in 2016. Bloomberg