Wolf, on a recent trip to China and Hong Kong, acknowledged that China is struggling with too much credit in the system. Debt nearly doubled since 2009 to just over 200% of GDP in 2015.
“Growth is slowing, debt servicing costs are rising and non-performing loans will continue to rise,” he said.
But he categorised the debt problem as a medium-term concern that will weigh on economic growth if it worsens.
“The debt problem has been mischaracterised as a crisis. It’s unlikely to spark a crisis in the traditional sense such as the US [subprime] crisis or the Asian financial crisis [in the late 1990s].
“Most banking assets are state-owned and corporate leverage is in state-owned enterprises. [Therefore] debts could be forgiven and banks recapitalised. Not without cost to economic growth, but a crisis could be prevented.”
“What people don’t understand is why are markets are reacting so sharply to a 1.8% RMB depreciation [but not] when the pound drops 8.5% or the yen drops 20%”
The RMB question
As capital outflows continue and China buys US dollars to support the RMB, authorities face difficult choices in managing currency depreciation.
Wolf said they have three options. One, a sharp devaluation, which is off the table because the resulting sharp volatility will roil global markets.
The second is mild depreciation of the currency, which Wolf said has some benefit but would increase the risk of more capital outflows.
“Chinese authorities are stuck with the third option – they will do their best at the moment to maintain stability until depreciation and capital outflow pressures ease and the environment will be better to introduce a more flexible exchange rate."
The key risk for China’s currency comes from the US Federal Reserve and the US dollar.
“A big risk is if we start to see rapid improvement in domestic US economic data and the Fed starts to raise interest rates. A lot of pressures on the RMB stem from broad US dollar strengthening over the last few years. If the dollar strengthens further, authorities may not want the RMB to follow it up.
“There is so much market focus on the USD and CNY exchange rate that [sharp depreciation of the RMB] could trigger more outflows into dollar-based assets.”
He said China has some capital controls in place and believes that outflows are likely to stabilise. “The $100bn-plus capital outflows [evident in December 2015] are not likely to happen again. People with means to move money out have already done it.”
Strong bearish sentiment
Investor sentiment toward China in the US investment community is overwhelmingly bearish. Kyle Bass, the founder of Dallas-based Hayman Capital, has repeatedly warned that China has a problem much larger than the 2008 US subprime crisis (which he predicted and profited from).
Wolf, who is based in Edinburgh, said European investors are more cautious than those in Asia, but not exceptionally bearish toward China.
In China itself, people have an understanding of the risks facing authorities, he said.
“But what people don’t understand is why are markets are reacting so sharply to a 1.8% RMB depreciation [but not] when the pound drops 8.5% or the yen drops 20%.”
He attributes market reaction to fear and uncertainty surrounding China’s policy goals and reforms, and to what extent authorities actually have the economy under control.
“[Authorities] are now making much more effort to communicate to markets their goals and intentions.”