Danger zone: what would the wider impact of a slowdown in China have on the Gulf?

Last week’s stock market crash in China sent shockwaves through global markets. We analyse what this means for the Middle East, which is already reeling from the fall in the price of oil.
Danger zone: what would the wider impact of a slowdown in China have on the Gulf?
By Ed Attwood, Courtney Trenwith and Sarah Townsend
Sat 29 Aug 2015 12:55 AM

It used to be said that when America sneezes, the rest of the world catches a cold. But if there was any doubt the title of the world’s most powerful economy was steadily shifting from west to east, that was dismantled in spectacular fashion last week. China’s sneeze — in the form of a stock exchange collapse that local authorities appeared powerless to prevent — sent markets around the world into meltdown.

“The key message from recent events is about declining confidence in the Chinese growth story,” says Duncan Innes-Ker, an Asia analyst at the Economist Intelligence Unit (EIU). “This is leading to a flight to low-risk assets among global investors that will put downward pressure on emerging market currencies and equity markets, even those with few direct linkages to China.”

As Arabian Business went to press last week, Asian markets had suffered an almost unprecedented period of volatility. Following on from two consecutive days of 8 percent falls on the Shanghai Composite during what has now been dubbed ‘Black Monday’ and Tuesday, neighbouring markets in Asia struggled to find their equilibrium. Over in the US, the Dow Jones Industrial Average fell by nearly 1,100 points after the opening bell on Monday, a collapse than was worse that the infamous ‘Flash Crash’ of 2010.

Nor were Gulf markets isolated from the contagion. The Saudi Tadawul, by far the biggest stock market in the region, dropped 6.9 percent on Sunday and 5.9 percent on Monday, ensuring that about $100bn of value was erased from the bourse during August. Other local stock markets followed suit, although most rose strongly again on Tuesday, with the Tadawul gaining 7.4 percent and stocks trading at their highest volume since May 2014.

“China has become the panic button for the global economy; another devaluation or a set of disappointing data has the potential to cause gyrations in global stock markets, with Gulf bourses at particular risk because fears related to China usually spill into commodity markets, which impacts regional stock volatility,” says Trevor McFarlane, the CEO of Dubai-based Emerging Markets Intelligence & Research (EMIR).

Certainly the Chinese crash came at an already volatile time for the Gulf economies, which are wrestling with a low oil price that is forcing each country to reassess its budget in the face of projected deficits over the next couple of years.

So what impact could a potential slowdown in China’s economy have on the Gulf?

The first point to make is that although there have been warning signs over Chinese growth for some time, a stock market crash does not necessarily presage a wider economic crisis.

“The slowdown in China is a slowdown, nothing more; it’s not a recession, it’s not a depreciation — far from it,” says John Sfakianakis, Middle East director at Riyadh-based Ashmore Group. “Having said that, yes, there are jitters.

“We have seen the stock market collapse 30 percent - that has been substantial. At the same time, the stock market was far ahead of what the economy was producing. That was because of excess liquidity in the system. That doesn’t mean the economy is going to falter.

“The equity markets in the GCC have fallen over the last two weeks by substantial amounts — a lot of wealth has been destroyed — that doesn’t mean that the Gulf as an economy would have been destroyed, far from it.”

The biggest headache for Chinese policymakers has been managing the transition from break-neck double-digit growth to a more manageable and sustained trajectory, or so-called ‘soft landing’. If they are unable to manage this switch from an economy that is driven by investment into one that is driven by consumption, then China risks a ‘hard landing’, a drastic slowing of the economy that could result in social and political instability.

Despite repeated attempts at fiscal and monetary stimulus, the Chinese economy is still weaker than expected, says Francis Cheung, the head of China-Hong Kong strategy at Credit Lyonnais Securities Asia (CLSA), an equities brokerage.

“The most puzzling part is why government stimulus has not worked this year,” Cheung says. “Numerous infrastructure projects have been announced since last year, but none had the effect of last year’s mini-stimulus, which had spurred a 30 percent market rally.

“This is the price of reform. With anti-corruption, a property price correction, a new budget law and banks swapping risky local government financing vehicle loans for low-yielding bonds, the mechanism for funding infrastructure has stalled.”

Nevertheless, the International Monetary Fund (IMF) projects a 6.8 percent increase in Chinese GDP this year, down from the 7.4 percent growth last year. In comments reported by Reuters last week, IMF executive director Carlo Cottarelli said it was “premature” to speak of a crisis, and that it was “perfectly natural” that a financial markets shock should occur in a country whose real economy was slowing.

“The slowdown in China has put downward pressure on oil prices, which affects GCC states,” says Afshin Molavi, a Washington, DC-based senior advisor at Oxford Analytica. “If the China slowdown leads to a hard landing, it will affect many of the leading eurozone and US industrial companies and exporters. Further slowing in Europe and sluggishness in the US would put additional downward pressure on oil prices, which would again hurt the GCC states.

“Thus, the key question should be: will China’s slowdown be a hard landing or a medium/soft one? My view is that China’s leaders have enough resources at their disposal to avoid a hard landing.”

Whether or not the Chinese economy is heading for a hard or soft landing, analysts agree that there will be little impact on China’s huge demand for oil. Saudi Arabia is its biggest supplier, and Oman also ships more than half of its oil exports to the Asian powerhouse. At the same time, however, Saudi exports to China made up only 13 percent of exports (or $44.2bn) last year, according to the IMF, while Bahrain also is hardly affected, given its more advanced diversification away from the commodity. Other countries are far more exposed; about a third of Australian exports go to China, while a quarter of South Korean exports head in the same direction.

“It is worth noting that trends in the oil market seem not to be driven much by developments in the Chinese economy,” says Innes-Ker. “Demand for oil products from China is likely to remain on its current path, and the price will remain under pressure from increased supply hitting international markets, notably from Iran”.

In return, the Gulf countries import a wealth of products from China. The Asian country is the UAE’s second-biggest import partner behind India, and that demand is also unlikely to change. In fact, due to the lower value of the yuan and the fact five of the GCC states are pegged to the US dollar, the GCC bloc will pay less for Chinese products.

“In terms of trade, the reality of the matter is that non-oil exports from the GCC to China have not grown substantially in the past ten years,” says Farouk Soussa, chief economist for the Middle East at Citi Global Markets. “Clearly, this is in part because oil has grown so massively, but even in real terms non-oil exports have been relatively stagnant.

“So it doesn’t really matter if the terms of trade between the two countries have changed. China only really imports oil — and demand is holding up — and the reverse is true: the GCC imports lots of non-oil goods from China, and with the depreciation, these goods are going to be cheaper.”

However, the fall in Chinese stock markets also affects the price of oil.

“The developments in China are impacting sentiment in financial markets which has sent oil prices marching down,” says Carla Slim, Standard Chartered’s economist for the MENA region. “This indirectly impacts GCC economies, which need the oil prices to be at much higher levels to balance their budgets.”

Financial ties are likely to remain strong, too, and the consensus is that the Gulf will not suffer unduly from a slowdown in interest from Chinese investors, particularly as the rush of Chinese private-sector funds into offshore markets is set to continue.

“The Gulf will be among many places where Chinese firms and individuals will be looking for investment opportunities,” says the EIU’s Innes-Ker. “However, it is not a market where they feel particularly comfortable investing at present, so Gulf economies are likely to benefit less from this effect than economies in Europe and the US.”

Finance links between the two regions have grown extraordinarily in recent years, with investment from Chinese companies into the MENA region rising to $30bn in 2013, up from just $2.4bn in 2005, according to HSBC.

“I think Chinese investors continue to have liquidity and continue to look at opportunities in the Gulf or in other places,” says Ashmore Group’s Sfakianakis. “I do not think that what we’ve seen to date will have long-term effects.”

The DIFC, which recently announced a ten-year strategy to triple its size by 2024, has been successful in attracting large Chinese companies such as Industrial Commercial Bank of China (ICBC) and Petro China to set up shop in Dubai’s financial hub. Alongside Qatar, it is vying to become an offshore renminbi centre, and says its plans remain on track despite the events of last week.

“Emerging markets in Asia, including of course China, remain fundamental to our long-term growth plan,” says Arif Amiri, the deputy CEO of the DIFC. “We are undeterred by market fluctuations.”

“It is, therefore, business as usual as far as our value proposition to China is concerned. A major component of our strategy is promoting the platform DIFC provides to access emerging markets. The MEASA region has an estimated combined GDP of $7.9 trillion, representing significant untapped potential for Chinese businesses, and for the wider business community in both developed and developing countries.”

At the same time, the immense amount of wealth lost by Chinese investors could have a trickle-down effect on tourism patterns and spending outside the mainland, some analysts believe.

About 350,000 Chinese tourists visited Dubai in 2014 (an increase of a quarter over 2013) and they spent nearly $1bn, according to figures from the Department of Tourism and Commerce Marketing (DTCM).

China became the emirate’s seventh-largest source market, up from tenth, a significant rise in only 12 months.

The figure is likely to increase to 540,000 by 2023, according to a report by InterContinental Hotels Group (IHG) and Oxford Economics, with the emirate remaining the most popular destination for Chinese tourists in the Middle East and North Africa for the foreseeable future. Abu Dhabi also is expected to receive more than 177,000 Chinese visitors by 2023, an increase of 300 percent compared to 2013, the report says.

“Dubai has always been a pricey destination, but thanks to the drop in the value of the yuan, Dubai will be even more expensive and you are likely to see a large fall in tourists from China,” says Binod Shankar, the managing director of the Dubai-based Genesis Institute.

“The expected drop in Chinese interest in the GCC is very akin to the fall in Russian spending in the UAE following their economic crisis in 2014. Then, Dubai not only saw a big drop in Russian tourists and hotel revenues but also a sharp fall in retail sales, as Russians are big buyers. The Chinese crisis will affect hotels more than retail as they spend relatively little on shopping in Dubai.”

In addition, there could be a much smaller impact on the Dubai property market, where about a thousand Chinese investors bought $350m (AED1.3bn) worth of real estate in 2013.

“This may take a hit due to the yuan devaluation which means that suddenly ‘cheaper’ Dubai properties now are much more expensive,” Shankar continues. “In addition, Chinese individuals may sell their Dubai properties for liquidity, to pay off debts and meet expenses back home.”

The impact of last week’s stock collapse, on its own terms, is likely to have relatively little effect on the GCC economies. But even if China’s economy performs more poorly than expected over the near to medium term, there are still plenty of reasons to be positive.

“If you look at China, the amazing thing is that it has a middle class of nearly 400 million people,” says Sfakianakis. “China needs to re-orientate from an outward looking market to an inward looking market. The inward would definitely want to [import] products and consumers products, partly these products come from the region, so it’s inevitable that the Gulf will continue to play a role.”

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