Chinese Economy to hit The Great Wall and Collapse?

For all the confidence in China's resilience to global economic shocks over the past decade, some investors are now starting to worry about a hard landing for the high-flying economic giant.

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Fears of a Chinese growth shock are compounding a broader sell-off bedevilling emerging markets, prompting many to raise cash levels and reposition portfolios to cope with an end to the China-driven commodities boom and a resurgent dollar.

Beyond the obvious impact on Asian markets, commodity-exporters South Africa and Brazil are seen as vulnerable while India and Turkey have been identified as relative beneficiaries should long-gestating fears over China be realised.

"I've rarely seen such a quick shift in market sentiment as I am seeing towards China. There was a near-total faith in the ability of the command economy to deal with the challenges," said Deutsche Bank strategist John-Paul Smith, who has been a long-term sceptic on the China investment story.

"But suddenly people are thinking that the government may have lost control over the economy."

A collapse in Chinese growth is at the top of global geopolitical and macroeconomic risks identified by advisory firm Oxford Analytica, which warns that annualised economic expansion there of less than 5 percent would be a massive shock to the global economy.

On top of growth worries, the protracted instability in the euro zone and the threat of global recession have fanned concern that China's drive to choke off credit to an overheated property market could hit its banks, whose deteriorating asset quality has prompted a ratings warning from Fitch.

Already, the cost of insuring Chinese sovereign debt against default has soared to 2-1/2 year highs as investors scramble to hedge exposure to Chinese corporate borrowers while offshore dollar/yuan forwards have jumped on expectations that currency appreciation will stall in the coming months to help the country cope with stuttering export growth.
    
Commodity Plays

Though it currently makes up only about 16 percent of the benchmark MSCI Emerging Markets Index, China's influence on the emerging-markets universe is significant.

The sizzling pace of its economic expansion, which has stayed above 9 percent annually in the last 10 years, has seen the country become a key growth driver for some developing economies, from which it imports vast quantities of commodities ranging from to iron ore and crude oil.

A stagnation in China's key manufacturing sector — activity in which tickedup in September after an all-time low PMI reading in August — and a slowdown in the property market will further weigh on commodity prices, piling further pressure on economies such as South Africa, Chile and Brazil, which all count on the Asian giant as their biggest trading partner.

"We've pared our currency positions on Brazil and Chile, which have a lot of direct exposure to China in terms of trade," said Morgan Harting, senior portfolio manager at Alliance Berstein in New York.

The Chilean peso is trading at a 14-month low while the Brazilian central bank, which has fretted about excessive currency appreciation for much of the last two years, has acted  to limit the real's recent slide against the dollar.  

Anticipating a fall-off in Chinese commodity demand, Deutsche Bank is underweight on Brazilian and Russian equities and overweight on Turkey and Poland, as these countries could see their current account gaps narrow as resource prices fall.
    
Stronger Dollar   

"India will also gain from lower commodity prices, but we would like to see lower valuations and a clearer road map for economic reform before we upgrade," Deutsche said.

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Alia Yousuf, fixed-income portfolio manager at ACPI, is also positioned for slower global growth: "We have exposure to India and Turkey as these could benefit from lower commodity prices."  

Lower commodity prices would ease inflationary pressures, and pave the way for central banks in Thailand, India and Indonesia to adopt a more stimulative stance, argues Ash Misra, head of investment at Lloyds Private Banking.

"When commodity prices come off, it's like an indirect tax break to almost all companies that pay for raw materials. We think the time to go overweight, especially in Asia-Pacific might be close," he said.

A Chinese growth slump would also have implications for the dollar, whose weakness in recent years has underpinned the rise of emerging markets.

A lower external trade surplus implies a slower rate of Chinese foreign-exchange reserves accumulation. This could mean less pressure on China to diversify its reserves away from the U.S. dollar, which has seen Beijing recycle part of its dollar assets into euros, but a slowdown in such purchases could allow for protracted dollar strength.

The dollar's strength and the consequent euro weakness [EUR=  1.3426    -0.0002 (-0.01%)   ] could be especially hard on emerging European currencies as these have a high beta to the single currency, said David Hauner, Head of EEMEA Economics and Fixed Income Strategy at BofA Merrill Lynch Global Research.

"With a prolonged period of dollar appreciation, the question is not where you can make money in emerging markets, but where you will lose the least money," he said.

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