China’s economic reset is likely to hurt world’s emerging economies

Countries that supply China with raw materials got a taste in January of what the future holds as the world’s second largest economy prepares to restructure itself and dampen its mega-growth of the last two decades.

Rattled investors engaged in a massive sell-off of stocks and currencies from so-called emerging markets, hammering countries from Brazil to South Africa that have profited from mining exports to China.

This won’t be the last time the world’s markets react – some would say overreact – to what some call China’s “rebalancing.” China is just getting started on boosting the domestic economy and scaling back the kinds of resource-intensive industries that have made it the world’s manufacturing giant. Because of China’s enormous size and economic clout, even a few baby steps can make the world tremble.

Michael Pettis, a professor of finance at Peking University, said China’s transition would harm numerous developing countries, particularly those that had invested heavily in exporting iron and other metals to China.

“There is no way around it,” said Pettis, who’s also a senior associate in the Asia Program at the Carnegie Endowment for International Peace. “If you are Brazil, Peru or Chile and you made a big bet on (metal) commodity prices, you are going to be very disappointed.”

China isn’t the sole source of financial headaches for certain emerging economies. The U.S. Federal Reserve has been “tapering off” its bond buying program that helped supply many of these countries with foreign capital to fuel their exports.

But for big mining industries in Brazil, Australia, South Africa and other countries, diminishing returns from China are looming, and alarming. China’s steel industry consumes more than 60 percent of the world’s iron ore imports; a staggering figure, given that China is also the world’s largest producer of iron ore.

China uses much of that steel to pump up the economy with government-funded infrastructure projects. But excess investment in subways, bridges, steel mills, housing projects and factories has left the country with massive debt and pollution problems. “Investment is like opium for government,” one Chinese business leader, Cheng Siwei, said in a story published Thursday in China Daily, a government-controlled newspaper.

Some U.S. economists said they were surprised at how world markets responded to reports that Chinese manufacturing had contracted in January for the first time in six months.

“We all knew that China’s growth rate had to slow. We all knew that the growth rates of the past 30 years were unsustainable,” said Jock O’Connell, a California-based trade economist. “Now, apparently, slower growth in China has investment analysts on Wall Street sounding a trifle hysterical.”

O’Connell noted that China’s gross domestic product is expected to grow this year at a very respectable pace: roughly 7.4 percent, as opposed to 7.7 percent last year, according to some estimates. But for Wall Street and world markets accustomed to years when China’s economy regularly hit double-digit growth, that drop is a disappointment.

It also comes amid rising concerns about China’s debt problems and so-called “shadow-banking” sector.

Dominated by government-controlled entities, China’s banking system is actually two systems. Regular depositors in this country of 1.3 billion people open accounts that offer low interest rates, supplying the government with cheap capital for infrastructure projects. Seeking higher returns, wealthier Chinese have been putting their money into investment funds and other forms of shadow banking, which largely are unregulated by the government.

In January, a major Chinese investment fund nearly went into default. The fund – issued by China Credit Trust Co. and marketed by Industrial and Commercial Bank of China Ltd., the world’s largest bank – was set up to raise money for a coal-mining company, the Shanxi Zhenfu Energy Group. When the company’s leading shareholder was arrested and accused of banking irregularities in 2012, it focused attention on the coal company’s finances and the riskiness of many shadow-banking investment funds. Days before a default was possible, China Credit somehow came up with the money to pay off investors, possibly helped by a bailout from a government-controlled bank that was worried about a “run” on other investment trusts.

Analysts differ on whether these trusts are a ticking time bomb for China. Victor Chu, a Chinese investment banker who’s the CEO of First Eastern Investment Group, acknowledges the rising debt of shadow banks but said recently that he thought it could be handled. “It’s still a manageable part of the system. . . . It’s totally manageable,” he said during a panel discussion on China at the World Economic Forum in Davos, Switzerland.

In order for China to “manage” its shadow banking and change its overall economic focus, it will have to enact policies that will upset some of its political elite, Pettis said. The nation’s staggering growth has been based on low interest rates for bank depositors, low wages for workers and an undervalued currency, all of which have promoted exports.

But that growth model has kept household spending low, resulting in an unbalanced economy. The government’s challenge now is to increase domestic spending, which will help some Chinese industries but hurt others that are dependent on the traditional economic model of heavy industry and exports.

On a global scale, Pettis said, the good news is that some countries will benefit from China’s transition, even as others are harmed. Wealthier Chinese families will want better meat and produce, giving countries that export food to China a boost. Countries such as Mexico also may benefit, he said, since their manufacturing bases will be better able to compete worldwide as China’s wages rise.

These changes won’t happen rapidly, Pettis said, but they have started and will surely cause more market eruptions as Beijing enacts them. “Keep an eye on China,” he said. “The next year will be very interesting.”

CORRECTION: An earlier version of this story contained an incomplete quote from Michael Pettis on developing countries and commodity prices.