Why China can still shock US stocks

Teh Eng Koon | AFP | Getty Images

A year after the weakening yuan sounded alarm bells on Chinese growth, the currency's moves have become far less worrisome for global markets even though it may take a while for investors to become more confident China has turned the corner.

"Much of the stability in China has come this year because they're downplaying reform this year relative to stability," said Paul Christopher, head global market strategist at Wells Fargo Investment Institute.

If GDP growth slows further to below a tipping point of 6.5 percent, "then the markets might be worried when China might deliver another deflationary shock to the world," he said.

Financial markets have become more at ease with China in the last several months, as recent data has indicated stabilization in economic growth and capital flight. But stimulus supported much of that growth, and the U.S. Federal Reserve's more accommodative policy has given China cover to stabilize its currency with the softness in the dollar.

Aggregate financing to the real economy, Beijing's measure of credit expansion, has climbed 7.87 percent on-year to 10.3 trillion yuan ($1.55 trillion) for the first seven months of the year, according to central bank data.

As stimulus likely tapers off and the dollar potentially rises with increasing signs of a Fed rate hike, China's struggles could come to the forefront again. Several analysts expect a pickup in signs of slowing growth in the next six months or so.

China posted its slowest GDP growth in 25 years in 2015 at 6.9 percent. First and second-quarter growth both came in at a 6.7 percent year-over-year pace. The third-quarter GDP report is due in mid-October.

UBS analysts "expect the cycle to peak in Q4. … That may force the authorities to react in Q4," said Jorge Mariscal, chief investment officer of emerging markets at UBS Wealth Management. He's watching for pressures from turnaround in economic data, Fed policy and protectionist rhetoric from the U.S. presidential campaign.

The other issue for global markets is China's leaders, who hold most of the keys to a smooth economic transition. The country is set to hold the 19th National Congress of the Communist Party of China next fall and some speculation of a power struggle is already circulating.

"The next round of U.S. market volatility could arise from a major political reshuffle or purge in China," wrote Clem Miller, investment analyst at Wilmington Trust Investment Advisors, in an email. He noted removal of "known market reformers from key government ministries" even before the congress meets could be taken negatively.

President Xi Jinping has promoted an anti-corruption campaign that has cracked down on many high-profile figures.

However, most China watchers who spoke with CNBC downplayed the likelihood of a significant power upset and said focus will be on the new leaders' ability to steer China smoothly through a transition from a manufacturing-based economy to a consumption-driven one. Efforts to wean China's reliance on the old growth model stalled this year as authorities prioritized stable growth.

"Whoever the new leadership team is, that team must declare what will be the balance between stimulus and reform," Christopher said.

Last August, when the Dow Jones industrial average dropped more than 1,000 points intraday in the days after the surprise Chinese yuan devaluation, the real issue was concerns over authorities' ability to manage China's economic transition. While the yuan's drop was part of an attempt to make the currency more market-driven, the decision came within weeks of China's heavy-handed efforts to prop up its deflated stock market.

In January, U.S. stocks had one of their worst starts to a year as commodity prices fell against the backdrop of China's continued struggles with its currency and its failure to effectively set up a circuit-breaker system in its stock market.

Then China eliminated the circuit breaker rules and replaced its stock market regulator. People's Bank of China Governor Zhou Xiaochuan sought to improve communication with the markets and said the country would not devalue its currency. Meanwhile, first-quarter economic data showed improvement.

"The People's Bank learned a lesson from that. If you want to introduce anything, you do it by stealth," said Arthur Kroeber, founding partner of Gavekal Dragonomics and author of "China's Economy: What Everyone Needs to Know."

He expects that until next fall's congress, "they're going to avoid any major sort of policy moves that could cause loss of confidence."

China is also achieving its goals of weakening its currency. In July, the yuan hit nearly six-year lows against the U.S. dollar, and last week, record lows against the months-old currency basket. A weaker Chinese currency helps exporters have a competitive edge against other emerging markets.


Longer term, Chinese authorities also want a stable yuan to promote its use internationally. The pace of depreciation in the last few months has been mostly gradual, helping ease global markets.

To be sure, Christopher noted a very large drop in the yuan would likely still trigger a sell-off. And underlying concerns about China's ability to pay off its debt-fueled growth could flare up again.

"The longer this credit growth goes on, the higher the risk is you're paving the way for a financial crisis," Kroeber said.