How A Chinese Economic Crisis Would Unfold In One Terrifying Slide

A cyclical recovery has seen sentiment shift on China and some have said that the economy has bottomed out. 

Societe Generale's Wei Yao expects Chinese GDP to increase 7.4 percent this year, but thinks there still is a "non-negligible risk" of a hard landing with growth of less than six percent. Remember a hard landing refers to four consecutive quarters of below six percent growth - which is the minimum needed for a stable job market and to avoid "systemic financial risk". 

In a new report titled "What If China Lands Hard?" Yao writes that clients they surveyed expect growth of between 5.5 - 7 percent in the worst reasonable case, but Yao thinks it could drop much lower to about 4 percent. 

So what would the two most likely causes of a hard landing be? According to Yao, the first would be a major trade shock, and the second, inadequate government investment from Beijing or a sharp property market correction prompted by tight policies to keep the market in check.

And how would this scenario play out? From Yao:

"Whatever the catalyst, the excess capacity in the manufacturing sector – estimated at 40% in 2011 by the IMF – would be exacerbated by a sharp growth slowdown. This would cut corporate margins sharply, making profits plunge, and triggering a downward spiral in domestic demand. Bankruptcies and unemployment would occur on a large scale, endangering financial and social stability.

One factor that could accelerate the downward spiral is the high leverage of China’s corporate sector, which exceeded 120% of GDP at end-2011 and has kept rising throughout 2012. As the crisis progressed, non-performing loans would undoubtedly rise beyond the capacity of local governments to contain them, as their fiscal resources dwindled.

Even in China’s (semi-) controlled system, banks could choose to freeze lending as a knee-jerk reaction, while the authorities rushed to draft a decisive response. The rapid development of the non-bank credit market in the last few years, especially shadow banking activities, has created a new vector through which a systemic liquidity crunch could take place. Capital outflow would likely ensue, stretching domestic liquidity conditions further."

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