Is China fragile? It could well surprise us – CNBC Comment

Xi Jinping has a dilemma on his hands
WITH earnings season in full swing, China remains the buzzword – but for all the wrong reasons. As analysts who have questioned the strength of the world’s second-largest economy start to look a lot less like Cassandras, the question remains: when will the Asian powerhouse stabilise?

Short answer: it’s tough to tell at this stage. But as we hear more downgrades to the outlook in the coming weeks tied to weakening growth, and even more headlines regarding Chinese market volatility, it’s important to note that some merely see this as the growing pains of an economy that could quickly turn around to surprise us.

Firms like Peugeot and Volkswagen continue to highlight the challenges of doing business in a slowing China. No one should be surprised. Most have been questioning the strength of reported growth for several quarters. Investors have also lost confidence in the face of extreme volatility in Chinese equity markets. The Shanghai Composite posted its worst monthly loss in almost six years in July, dropping 14.3 per cent.

But the index did manage a 130 per cent rally over the last 12 months – all in the context of growth being revised lower, corporate profitability being squeezed, and a sharp hike in non-performing loans at the banks that dominate the index. If we were able to deal with weakening economic growth on the market’s way up, surely we shouldn’t worry more on the way down?

Of course, it’s easier said than done to assess China’s equity market apart from its economy when Beijing is taking unprecedented steps to stem the tide of outflows. China isn’t the first country to try to prop up markets, but that’s the only policy defence I can provide, as its efforts are clearly unsustainable even in the short term. The question now is whether authorities continue down this interventionist track, or pull back and allow monetary policy to carry the burden, through further cuts to bank reserve requirements and benchmark rates. Otherwise, Chinese officials could end up backing themselves more firmly into a corner with additional restrictive measures that ultimately risk a greater surge in volatility in the future.

And China faces other risks -- such as the impact on its international profile. Last Friday, regulators said they would strengthen the supervision of program trading after sharp swings in the stock market. They have already suspended several trading accounts for irrelegular trading activity. Can we assume that domestic trading accounts were scrutinised to the same degree as foreign?

What damage will the combination of weakening growth, intervention and greater scrutiny do for inbound investment? There’s a definite sense that firms operating in China understand the slowdown is part of a structural adjustment to a less growth-intensive model rather than a cyclical downturn.

But why does that have to be a bad thing? Whenever it feels like a strong consensus is building in financial markets, it can often be time for a rethink.

Steen Jakobsen, chief economist at Saxobank, told CNBC’s Squawkbox this week that “financial deregulation is happening faster than anyone ever thought”, for example. So while we’re focusing on China’s interference to support the stock market, behind the scenes China is quietly liberalising.

Further, while many ask whether the Chinese government will devalue its currency to support growth, Jakobsen says we haven’t seen anything yet: “The RMB will overtake sterling as the number three currency (in FX volume) in less than three years. China will dictate the cost of money, but China will also be engineering a global restart of growth exactly as it did in 2008, but this time the plan is more grand and ambitious.”

He argues that China’s Silk Road investment plan will spread to the rest of the world over the next two years as China tries to create one big trading zone across Asia. And “what China does with its $3-4 trillion reserves is far more important ultimately than if and when the Federal Reserve hikes rates.”

Two years may feel like a lifetime, particularly given market volatility, questionable data and uncertainty over the policy response. But it’s worth bearing in mind that China has always had the potential to adjust more quickly than we imagined.

Julia Chatterley is an anchor on CNBC.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.