How China’s Market Turmoil Affects Japan

J-Money, November 2015

The turmoil in Chinese markets, and the increasing doubts about the future of the Chinese economy, have had knock-on effects all over the world – certainly including Japan.

There was a time when problems in China would have meant little to the Japanese economy, but those times are gone. Today, China represents a vital trading partner. In 2014, according to data from the Japanese External Trade Organization, China accounted for 18.3% of Japan’s exports and 22.3% of imports.

Consequently, the plunge in the Chinese A-share markets was partly reflected in Japan’s stock markets too. On the worst day of the China rout in August, the Nikkei 225 fell 4%, its largest fall for more than two years.

The external shock from China is very badly timed for Japan, where the economy contracted by 1.6% year on year in the second quarter. It risks undermining the Abenomics stimulus programme and it could prompt the Bank of Japan to ease monetary policy still further, rather than just relying on its asset buying programme to overcome deflation.

Two questions are important: how bad China’s situation is, and how exposed to it Japan is.

On the first point, the mood is bearish. “China’s economic model seems to be running out of steam,” says Amundi Asset Management. “Lending is excessive, debt is ballooning, the shadow banking system is poorly regulated, industrial competitiveness is eroding, productivity gains are falling and potential growth is down.” Amundi calculates that, given demographics and productivity gains, potential growth in China is about 50% lower today than it was 10 years ago.

Amundi believes the lack of belief in the Chinese model was “starkly revealed by the recent decision to allow the yuan to depreciate and the depletion of the foreign exchange reserves by almost $300 billion in a year.” Amundi expects 6% growth in 2015 and 2016, “though with a risk that growth could be even lower.”

Standard Life is pessimistic too, but for different reasons. It says that in the global financial crisis, China’s response was to use state banks to distribute nearly $600 billion to state-owned enterprises to fund infrastructure projects and to increase manufacturing capacity. But this can’t be done again. “In China’s current situation, those same SOEs are riddled with overcapacity and there are far fewer infrastructure projects that will offer a return on investment.” A credit boost of the kind China tried in 2009 would only heighten the risks to China’s banking sector. “Simply put, China’s options are limited.”

The alternative view is that even if China’s growth is slowing, that doesn’t mean it is in trouble. “China’s growth is slowing to 6-7%,” says Agatha Lee at JP Morgan. “In the past it has always had double digit, but it will still be a bigger number than, for example, Korea.” In this argument, a slowdown in China has been inevitable for many years and should not be seen as a shock or even a negative, simply something that must be adjusted to.

The next question is the impact on Japan.

Goldman Sachs chief Japan economist Naohiko Baba has said that China – like the US – absorbs about 2% of Japan’s value-added goods, and that a fall of one percentage point in China’s domestic demand costs Japan 0.1 per cent of gross domestic product.

Also, significant though that 18.3% figure for China’s proportion of Japan’s exports is, the true impact is worse still. 54% of Japanese exports go to Asia, and China’s slowdown affects all Asian economies, reducing all of their appetite for goods. The IMF, in its Spillover Report for 2014, said that a one percentage point decline in emerging market growth leads to a 0.5 per cent percentage point fall in Japanese growth. So in other words, if a slowdown in China means a slowdown in all emerging markets, then the outcome for Japan is much worse than might be implied by just looking at China-Japan trade figures.

Bank of Japan deputy governor Hiroshi Nakaso specifically warned about these impacts in July, saying the effect of a Chinese slowdown “on Japanese exports warrants due attention,” although he said Japan’s economy could cope with these risks.

And apparently he is not alone in his concern. According to a Nikkei survey of top managers at 148 major Japanese companies conducted in September, 64.1% of respondents said that China’s economic slowdown would have a negative impact on them, chiefly because of declining exports. Some are taking action already: Kobelco Construction Machinery, a unit of Kobe Steel, has already said it will cut 200 positions in China – 10% of its workforce there – by the end of the year.

International asset managers have formed a similar view. “The three advanced economies that stand out for having the largest direct exposure to emerging market growth are Australia, Japan and Korea, where exports to final demand account for more than 50% of total exports,” says Standard Life. “This is not a reason to panic, as long as emerging markets are slowing but not collapsing. However, it does help explain why advanced economy central banks are so sensitive to foreign developments.”

On top of that is the currency angle. China has already devalued its own currency as a response to its stock market fall and its weakening economy. Naturally, that means a relatively stronger yen against the renminbi, but in practice it can also lead to a stronger yen against all currencies. Japanese fixed income is seen as a safe haven when global risk aversion is high – and a Chinese slow down prompts the world to become very risk averse. That pushes the yen up, and in turn can hurt the Japanese stock market.

Susan Joho, economist at Julius Baer, expects the Chinese currency to stabilize at a level of around USD/CNY6.8. “What seems already clear now is that the volatility of the yuan will be markedly higher under the new regime,” she says. That is not helpful for Japan.

Some go further and believe that Chinese devaluation has the impact to damage global as well as Japanese growth. “From time to time, clients ask what keeps me awake at night,” says Marino Valensise, head of Barings’ Multi Asset Group. “My answer has been that while I struggle to identify the next black swan, a sudden and substantial devaluation of the Chinese renminbi has the potential to be a game changer in global markets. You might call this a ‘red swan’ event.” China’s devaluation, at 3%, does not seem so drastic, and Valensise points out that even after devaluation the RMB is up 35% relative to the yen over the last three years. But Valensise also notes that in recent years a strong RMB has been good for the global economy, including Japan. “It is now clear that the future will be different and that we will have to live without such a support mechanism.”

Still, even if all of this is correct, it does not automatically mean that Abenomics is derailed. It is, by and large, considered to be making progress, and periods of profit-taking and weakness are to be expected along the way. Nevertheless, Chinese turmoil is an additional challenge that the Japanese economy just did not need.