Financial markets have seemingly shrugged off recent saber rattling on the Korean Peninsula. However, a bigger problem may be looming for the region if China fails to bring its debt mountain under control.
Fiery rhetoric from both Washington and Pyongyang has failed to shake financial markets, despite the leaders of both sides upping the ante in recent weeks. North Korea has threatened to “blow the U.S. from this planet,” while U.S. President Donald Trump declared U.S. forces were “locked and loaded” ready to inflict “fire and fury” in response to any attack.
After an initial spike in volatility and jump in “safe haven” assets such as the Japanese yen, U.S. Treasuries, and gold, reassuring comments by top U.S. officials and an apparent backdown by Pyongyang helped calm markets.
At close of trade Friday, Korean stocks had gained over 16 percent for the year, while the Korean won has appreciated against the U.S. dollar, becoming Asia’s top performing currency in July despite higher U.S. interest rates and the threat from its neighbor.
Japanese stocks have also gained around 2 percent this year, despite the negative effects of a strengthening yen, while Shanghai stocks were up around 5 percent as of Friday.
One beneficiary of the geopolitical tensions has been gold, which has risen by 12 percent this year on the back of the Korean crisis as well as the slower than expected pace of U.S. interest rate hikes.
Analysts suggest the muted response to the North Korean crisis reflects the difficulty in “pricing in” the consequences of a nuclear confrontation, as well as a sense of déjà vu over Pyongyang’s repeated threats.
“Maybe market participants realize that North Korea has generated many false alarms over the past decade, so are reflexively reaching for the snooze button,” JP Morgan’s John Normand said.
“Or maybe they struggle to equate stronger rhetoric with actual conflict given the protagonists.”
China Shock
However, an emerging threat to the region’s economic growth has re-emerged, with increasing warnings over China’s escalating debt.
In its latest country focus, the International Monetary Fund (IMF) upgraded the growth outlook for Asia’s largest economy to an average of 6.4 percent a year through to 2021, compared to 6 percent previously. The world’s second-largest economy is expected to expand by 6.7 percent in 2017, following policy easing and supply-side reforms, dropping to 6.4 percent in 2018.
However, the IMF said the faster pace of growth would come at the cost of increased debt. China’s total non-financial sector debt, including corporate, government and household debt, is expected to reach almost 300 percent of gross domestic product (GDP) by 2022, up from 242 percent in 2016, as Beijing strives to achieve its goal of doubling 2010 real GDP by 2020.
A key consequence of the debt ramp-up is a “higher probability of a sharp adjustment,” potentially triggered by a funding shock, trade war, or surge in capital outflows. “This raises concerns for a possible sharp decline in growth in the medium term,” the Washington-based institution said.
The IMF urged Beijing to address the issue through greater “deleveraging efforts” in the private sector, raising consumption’s share of GDP compared to investment, and enhancing social spending to reduce income inequality, “which is among the highest in the world.”
Productivity could also be enhanced by reducing the amount of resources going to loss-making “zombie” companies, “overcapacity” industries and state-owned enterprises (SOEs), with the potential to boost productivity’s contribution to growth by about 1 percentage point over the longer term.
Yet China “bears” such as analyst Charlene Chu have suggested the real bad debt figure in China is up to $6.8 trillion more than official estimates, making it important in “global terms.”
Chu suggests bad debts in China’s financial system will reach $7.6 trillion by year-end, more than five times the official value of non-performing bank loans, implying a bad debt ratio of 34 percent compared to the official 5.3 percent.
According to Chu, Beijing’s influence over both borrowers and lenders has allowed it to delay dealing with such problems longer than might be possible in a market-driven system.
Capital Economics’ Julian Evans-Pritchard argues Beijing could address the problem by taking bad loans onto the government’s balance sheet, but doubts the political will exists to confront SOEs.
“By not resolving the issue around allocating credit the economy will underperform and growth will continue to slide,” he told the Australian Financial Review.
“We believe growth in China will average 2 percent over the next decade.”
Such a slide would have a negative impact on Asia’s growth outlook, given China’s position as the major trading partner for much of the regional economies and its influence on commodity prices as the world’s biggest resource consumer.
However, not all China economists are gloomy on the outlook.
“The Chinese government has a lot of policy options to head off a debt crisis, but that will require political will which should become stronger after the 19th Party Congress,” Citigroup’s Liu Li-Gang told the Australian financial daily.
Liu believes economic reforms will accelerate after the fall congress, which is expected to cement Chinese President Xi Jinping’s grip on power. He pointed to China Unicom’s announced plan to sell around a third of its shares to private investors as an indication of the potential for greater SOE reform.
“The Chinese state still has a very strong balance sheet, with twice as many assets as liabilities,” he said.
Hard Landing
Nevertheless, the Economist Intelligence Unit’s (EIU) John Marrett has pointed to a China slowdown from 2018 “after the political transition has been secured in Xi’s favor.” He suggested the authorities would also seek to tackle financial issues before 2021, the Chinese Communist Party’s 100th anniversary.
“The trigger will be the authorities stepping in more firmly to rein in credit and encourage deleveraging, such as tightening monetary policy, paring back open market operations and raising policy interest rates… [as well as] steps to enhance financial regulatory oversight, such as by restricting debt issuance in certain sectors considered overleveraged,” he said on August 9.
“The effect will be a hard landing, in that growth will decelerate by the steepest inclement since the global financial crisis,” he said.
“Real estate and construction will be hit the hardest. Gross fixed investment will take a substantial hit, while private consumption will remain relatively unscathed, helped by unemployment remaining fairly low.”
As a result, China’s GDP growth will contract from an estimated 6.8 percent in 2017 to just 4.6 percent next year, according to the EIU.
The EIU analyst said commodities prices would drop, hitting major exporters such as Australia, Indonesia and Mongolia. However, India and Japan would be less affected due to their more diversified export destinations, “compared to countries closer to China and with a heavy commodity dependency.”
The effects would spread to currency markets, with those most exposed to China trade losing ground against the U.S. dollar, including South Korea and Taiwan. Japan, a regional trade haven, would instead see its currency strengthen as confidence in other regional currencies declines.
Nevertheless, the EIU still sees the Asia-Pacific region continuing its economic expansion in 2018, helped by infrastructure upgrades, growing consumption and rising interregional trade.
India is seen leading the pack, expanding by 7.9 percent in 2018 compared to this year’s 7.3 percent, followed by Cambodia’s 7.2 percent GDP gain and Vietnam’s 6.5 percent in 2018. Japan, Asia’s second-largest economy, is expected to ease from 1.5 percent GDP growth in 2017 to 1 percent next year, while both Australia and New Zealand are seen growing above 2 percent this year and next.
“The economic distress caused by China’s slowdown won’t be enough to be politically destabilizing to Asia and China… we see a dip in growth but not a devastating one,” he said.
War on the Korean Peninsula could cause millions of deaths and long-lasting economic damage to some of Asia’s biggest economies. Yet with the crisis apparently easing, China’s ability to deal with its debt issues could soon become a more pressing issue for Asia and the world.