Turning Point for China’s Economy?

Uh oh.  Have we finally reached the turning point for China's economy?  Per Caixin:

 

(Beijing) – China's services sector continued to expand in December, albeit with less strength than in previous months, according to the latest Caixin China Services Purchasing Manager's Index.

December's index of 50.2 pointed to nationwide expansion for service business in general, even though the figure was down from 51.2 in November. It was also the second-lowest figure for the sector since record-keeping began in November 2005. The weakest services PMI ever recorded was 50 in July 2014.

The nation's services sector has been growing against the backdrop of a weakening manufacturing sector. As a result, the Caixin China Composite Output Index, which covers services and manufacturing, fell below the neutral 50-point level to 49.4 in December, compared with 50.5 in November.

Composite index figures from the second half of 2015 pointed to a decline for China's overall business activity in four of the year's final five months.

Both manufacturers and service providers reported softer client demand in December. The services sector hired more workers while manufacturers continued to reduce staff numbers. Taken together, the sectors' combined employment environment deteriorated for the seventh month in a row in December.

Meanwhile, service providers said their work backlogs did not change much from November to December, ending a 10-month streak of backlog reductions.

Both sectors continued cutting prices in December, a sign of persistent deflationary pressure. Dr. He Fan, chief economist of Caixin Insight Group, called for government action to address the threat.

"In light of the setback to services sector growth, the government needs to gradually relax restrictions in the sector," said He. "This will release the potential of supply-side reform, improve the economic structure, and help with industrial transformation and upgrading."

The further a PMI figure is away from the neutral 50-point level, the more that sector of the economy contracted or expanded in a given month.

China watchers are increasingly worried that we will see a replay of China's RMB devaluation from August 2015.  Here's the FT's Gavyn Davies:

 

The risk of a large devaluation in the Chinese renminbi is once again spooking markets, which are firmly convinced that this as a very bad contingency for global risk assets in 2016. As last year ended, investors became more relaxed about the threat, following a series of veiled announcements from the PBoC about its currency strategy. These statements seemed to suggest that the central bank would broadly stabilise the effective exchange rate against a currency basket from now on, while allowing greater flexibility against a (possibly) rising dollar.

Since the dawn of the new year, however, investors have become much more concerned that a larger devaluation may be in the works, either through the choice of the Chinese authorities, or because the outflow of private capital is getting out of hand. Some bears in the currency markets believe that China could soon be suffering from a genuine exchange rate crisis, in which its enormous foreign exchange reserves could be quickly drained.

Why have markets recently become so nervous about a Chinese devaluation? It is largely because there is still so much uncertainty about the exact regime that the authorities are pursuing. Late last year, shortly after being admitted to the International Monetary Fund’s Special Drawing Rights, the Chinese authorities drew attention to a new currency basket for the renminbi, and pointed out that the exchange rate had been basically stable against this basket since its base date on 31 December 2014. They also said, in their own translation from the Chinese language statement, that

The abundant foreign exchange reserves, the sound fiscal standing and a robust financial system jointly provide a solid foundation for the RMB exchange rate to remain basically stable at an adaptive and equilibrium level.

Note that this falls short of a firm commitment to a stable range, but it is a clear hint that they do not want or expect the renminbi to decline much against the basket for the immediate future.

Since then, further large moves in the exchange rate have taken place:

The depreciation in the renminbi against the dollar has been particularly large in the offshore market (CNH), but has also taken place in the onshore market (CNY), which is more controlled by the PBoC. The CNH/CNY gap has now risen to more than 1.95 per cent, slightly wider than the previous extremes reached in 2011.

Since this gap suggests that the onshore renminbi is not “freely usable” — a key criterion for SDR entry — this is embarrassing for the PBoC. It may also encourage further capital flight as confidence collapses in the offshore market.

However, many observers suspect that there was an informal “understanding” with the US (which, remember, still argues that the renminbi is undervalued) to eschew a sharp devaluation. China’s already strained economic relationship with the US would be ruined if it deliberately devalued so soon after its longstanding desire for SDR entry had been achieved.

What it does suggest, however, is that private sector capital outflows have been very large recently. Market sources reckon that private capital outflows may be running at $10bn a day, slightly more than occurred during the crisis last August. Official foreign exchange reserves have declined by $213bn, from $3,651bn last July to $3,438bn at the end of November, and will probably have dropped further when the December figures appear on Thursday.

In addition, China bears point out that the “errors and omissions” category in the official balance of payments data has risen by around $200bn since 2013, possibly indicating that the private capital outflow has been much larger than shown in the official data. These bears are beginning to convince themselves that the PBoC could soon run out of liquid foreign exchange reserves, making it impossible for them to continue supporting the currency.

As much as the general markets are troubled by the possibility of devaluation, Gavyn Davies remains bullish on China, and thinks a devaluation is unlikely:

The big question, therefore, is whether the PBoC will in fact choose to keep the renminbi in its fairly stable band against the official basket. As the second graph (above) shows, the effective rate has now fallen to the low points of last year’s trading range, and a further sustained fall would call into question the PBoC’s commitment to broad “stability” against the basket. If that happened, Chinese and global financial markets might conclude that a large devaluation will inevitably occur this year, and bring forward the endgame.

My expectation is that the Chinese authorities will seek to maintain their objective of broad stability against the basket. Recent Chinese activity data have been fairly encouraging (see the “nowcast” graph [above]), the current account of the balance of payments is in large and rising surplus, and a devaluation would undermine the key objective of rebalancing the economy away from moribund manufacturing sectors. It would also require a recapitalisation of the Chinese financial system, which has direct and indirect exposure to China’s $900bn foreign debt mountain. Finally, it would certainly inflame the Republicans, as well as some Democrats, in a US election year.

If this expectation is correct, then the PBoC will soon need to intervene on a large scale to reverse part of the recent depreciation — not to defend a particular exchange rate floor, but to prevent extrapolative expectations of devaluation from becoming self-fulfilling. If the central bank passively permits the renminbi to continue its downward drift, the situation could rapidly get out of its control.

Still, here's Bloomberg:

 

“China is still a very underestimated risk,” Rainer Michael Preiss, a strategist at Taurus Wealth Advisors Ltd., told Bloomberg TV in Singapore. “The most elegant way out of a very complicated problem is to further devalue the currency and that would have a very negative impact on Asia in particular but also on other emerging markets. That’s not fully priced in.”

The People’s Bank of China lowered the yuan reference rate by 0.22 percent, the most since Nov. 3, to 6.5314 per dollar. The gap between the yuan rate inside China and that for the currency traded offshore expanded, underscoring speculation the government faces pressure to devalue its currency to aid the economy. 

As China's economy becomes more complex, the solutions also become more complex, and with more mixed results.  Intervention may calm fears of depreciation, but would also mark a backtracking from pledges of market reforms.  We are rapidly approaching a critical turning point, where China decides it must either endure the short-term pain that is necessary to rebalance its economy and ensure that growth remains robust, if slower in the years ahead, or if instead it will cling to the old debt-driven investment model as Japan did before it.

No one should hope for a hard landing in China, as the repercussions would be severe across the world.  The market certainly isn't taking Caixin's news or the RMB's latest reference rate lightly: