geopolitical risk ratings firm

China – Drop in Stock Market Could Have Political Implications


      One Year
Five Years
Risk Category Year
Political Risk 56.0 56.5 53.0 65.0 50.5 69.0
Financial Risk 47.5 48.0 44.0 48.5 36.0 49.0
Economic Risk 40.0 41.5 39.0 42.5 32.5 44.0
Composite Risk 71.8 73.0 68.0 78.0 59.5 81.0
Risk Band Low Low  Mod. Low High V. Low

Government Stability/Investment Profile
Drop in Stock Market Could Have Political Implications
Although Xi Jinping’s position at the head of the Chinese Communist Party (CCP) is secure, the potential for possible political instability was highlighted when the country’s stock market lost roughly one-third of its value in June and July. The government intervened strongly to help stop that slide (roughly US$2.7 trillion worth of funds were erased in three weeks), initiating a number of steps that helped stem the downturn, including cutting interest rates and transaction fees, suspending Initial Public Offerings (IPOs), and allowing the national pension fund to buy stocks.
Those actions appear to have averted a larger crisis, which means the damage to the overall economy will likely be minimal. However, the episode reinforced the importance of continued economic growth to the CCP’s dominance of the political system.
There is a wide body of literature about the need for China to move away from its export and infrastructure-based economic model to one that prioritizes domestic spending. Under Xi, the government has taken some steps to liberalize the economy, with China’s president stressing the need for market-based reforms at multiple junctures.
There are at least two prominent political dangers associated with such a shift. The first is that the restructuring of the economy might lead to a downturn in growth that might endanger the CCP’s position. The second is that, in the course of re-distributing the wealth from large state-owned companies to a new class of business owners, there are a number of powerful actors who will not see it as in their best interest to support wholesale changes and can therefore be expected to resist. An example of this latter dynamic was seen recently when Beijing pressed local governments to eliminate tax incentives used to lure foreign businesses. This caused Foxconn, the Taiwan-based assembler of Apple products, to re-consider expansion plans into China, which, in turn, led the local governments to complain to Beijing, which ultimately reversed course.
In both cases, there would be an increased probability of rifts or factions developing within the CCP. Already, Xi has pursued an aggressive anti-corruption campaign, purging a number of high-ranking officials from the CCP, including Zhou Yongkang, a former security tsar who was sentenced in June to a life-term in prison, and Ma Jian, the Vice Minister in the Ministry of State Security. These moves were notable in that they were interpreted as strengthening Xi’s position against potential rivals, but they also have the potential to foment discord within the upper reaches of the CCP.
The stock market crash and ensuing government intervention in June and July showed that Xi is willing to step away from his market rhetoric when faced with a significant threat. While that might mitigate some of the political risks described in the previous paragraphs, the volatility of the market points to an even bigger danger—even if Xi chooses not to be aggressive in challenging the elite, some of the structural challenges associated with the economy, including the speculative bubble associated with the stock market, may be beyond Beijing’s control to manage. If that proves to be the case and there is a market panic or severe economic downturn that undermines the country’s sense of financial well-being, then the public may be motivated to mobilize for political change.
Launching of AIIB Could Ameliorate Some Regional Tensions
The Asian Infrastructure Investment Bank (AIIB) was launched in June as part of a ceremony at the Great Hall of the People in Beijing. The 57-nation bank will have a capital stock of US$100 billion that will be used to finance regional transportation, energy and water infrastructure.
Concerns the AIIB would be a strategic vessel for China as well as worries about environmental and social safeguards prompted the US to encourage its allies not to join the initiative. And while China has provided the largest amount of funds and has biggest voting bloc, nations such as Australia, Britain and South Korea were satisfied enough by the regulatory framework to participate. Instead of being an outlet to expand influence, Chinese leaders have pitched the AIIB as an opportunity to promote regional cooperation. In pursuit of this aim, Beijing also announced in April a US$46 billion investment in infrastructure in Pakistan as part of what is being billed as the region’s new Silk Road.
While such projects are intended to foster goodwill, there are other developments that could exacerbate tension in the region. After clearing the US Senate, the 12-nation Trans-Pacific Partnership (TPP) is closer to becoming a reality. While Chinese officials have not expressed public alarm in recent months about the trade pact, American leaders have been explicit in framing the TPP as an opportunity to contain China’s influence.
Meanwhile, the Chinese government also passed a new national security law in July. In recent years, Chinese officials have taken steps to expand the list of the country’s “core interests” beyond Taiwan, Tibet and Xinjiang, which are territories or provinces that Beijing claims sovereignty over. The national security law continued that trend, promising the government would be vigilant in protecting the country’s assets. Lately, this watchfulness has seen China assert itself its right to disputed territory in the South China Sea; in July, a US-based think tank (the Centre for International and Strategic Studies) released satellite images that it said showed China had built a runaway that could be used for military airplanes on a contested island in the region.
Even with the formation of the AIIB, such incidents will mean that regional tensions will continue to percolate. The September state visit by President Xi to Washington for meetings with US president Barack Obama offers some promise—the two leaders can be expected to devote significant time to maritime issues as well as cyber security. The recent agreement between the two countries in reducing carbon emissions in the fight against global warming suggests the two sides can forge agreements; however, since the South China Sea represents a “core interest” for China, the potential for a breakthrough on maritime issues may be more remote.
Economic Slowdown Likely to Continue
In mid-July, at roughly the same time the stock market reached its nadir, the Chinese National Bureau of Statistics released its economic data for the second quarter of the year. Most outside observers anticipated GDP growth to come in below the government’s target of 7%, but the economy exceeded expectations by expanding right at an annualized rate of 7%.
Since much of the underlying data dropped compared to the first quarter—industrial production, retail sales and fixed-asset investment were all down—there is some reason to be skeptical about the government’s headline growth rate. If one is more inclined to believe the economy only expanded somewhere in the neighborhood of 6-7%, it is possible a slowdown could become even more pronounced in the second half of the year. In addition to the possible bursting of the stock market bubble discussed earlier, other downside risks include weak global demand and slowing real estate demand.
If one is more prone to take the official data at face value, the economy’s stronger-than-expected performance can be credited to the central bank’s loose monetary policy as well as fiscal measures that included a glut of recently announced infrastructure projects. Encouragingly, the National Bureau of Statistics reported in July that domestic consumption accounted for 60% of China’s economic growth in the first half of the year, compared to 51.2% in 2014; with the consumer price index projected to increase at a decreasing rate over the second half of 2015, households can be expected to have even more discretionary income, further boosting domestic consumption to help maintain GDP growth close to its current trajectory.
With the global drop in oil prices as well as the economic slowdown, inflationary pressure in China will likely be subdued for the remainder of 2015. The central bank is forecasting that consumer prices will increase 1.4% for the year. At the end of May, data from the bank indicated that annualized consumer inflation stood at 1.2%, which was its lowest level since January, when it was 0.8%. With the producer price index (PPI) maintaining its downward trend for more than three years, deflation cannot be completely ruled out; however, the most likely scenario is that strengthening domestic demand and the interest rate cuts will keep inflation between 0.5–1.5% for the year.
In June, the People’s Bank of China, the country’s central bank, cut the one-year lending and deposit rates for the fourth time in seven months to 4.85% and 2%, respectively. The latest decrease was made in an effort to increase liquidity in the midst of the stock market plunge. Moving forward, the deposit rates can be expected to move higher in tandem with inflation, which should increase in 2016 as global oil prices recover.
Until the stock market troubles in the middle of the year, the yuan had performed strongly against the US dollar in 2015. With foreign investors pulling their money out to guard against exposure in the Chinese market, that trend reversed itself, although for the year the yuan is only down 0.02% against the dollar. With the central bank’s vast foreign reserves and active monetary policy, there is little reason to expect strong swings in the yuan-to-US dollar exchange rate over the remainder of the year, although that does mean the US dollar’s upward course will push the yuan higher against the Euro and the Yen.
Finally, the central bank recently increased its forecast for the current account surplus to 2.9% of GDP. The impetus for the change was encouraging export and import trends, including a reduced oil import bill. Long term, this trend can be expected to change as rising costs slow exports and increasing domestic wealth increases demand for imports; however, for 2015, China’s current account surplus can comfortably be expected to be between 2.5-3% of GDP.


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