HONG KONG -- China's local government debt, shadow banking and attempts at structural reform have left the country on a precipice. If it falls over the edge, which countries will be hit hardest, asks UBS.
Emerging market turbulence has calmed for now. The U.S. Federal Reserve's decision to reduce the amount of money it is pumping into the economy could change that. Such circumstances present a further risk for China, a superpower in emerging countries.
The UBS report, written by economist Wang Tao and others, explored how a hard landing for China would impact trade and finance, and contagion risk.
Mongolia's exports to China account for 90% of the total from the country. Taiwan's exports to China accounting for slightly less than 40% of the total, while exports from Australia and South Korea each add up to almost 30%. Estimating impact, however, is more complicated than just looking at export volume. Slightly more than 40% of exports to China are sent back overseas. UBS therefore looked at countries whose exports are directly linked to China's domestic demand. Mongolia came in first again, followed by Taiwan, Zambia, South Korea and Chile. Also Vietnam, Malaysia and Singapore, Asean members, are included.
These countries' economies are likely to be hurt in the case of a hard landing for China. Meanwhile, according to the report, exports to China from Germany and Japan are heavily dependent on investment goods, including production facilities. U.S. and Europe have a low dependence on exports to China.
In terms of finance, Hong Kong and Singapore are at much greater risk than other places. Capital transactions are tightly restricted in China. Hong Kong, Singapore, Taiwan and some other regions and countries, however, are allowed to conduct yuan-denominated transactions. In these economies, banks' China-related assets tend to be high. In Hong Kong, banks' China-related assets for the July-September quarter of 2013 rose to above 18% of the total. Singapore's stand at slightly more than 8% and Taiwan's at a little above 2%. These figures largely rely on trade finance operations or such. According to the report, this is good news, as the banks are not lending large amounts of money to Chinese companies.
The report suggests that the financial impact of a hard landing by China would be limited because the country's investment activity focuses on resource-rich Asian and African nations.
It is almost certain that there will be contagion in the event of a serious economic slowdown in China. In other words, countries that do not have trade or financial links with China are still likely to experience some pain. The Asian economic crisis, which started in 1997 in Thailand, quickly spread into Southeast Asia and South Korea. But East Asia learned from its past mistakes. Emerging countries now have more foreign currency reserves, which has reduced foreign-currency-denominated debt. Despite this, the size of China means the impact of any crisis would be significant.
UBS said that a number of economies are vulnerable to events outside their borders because of large current-account deficits and capital inflows. Mongolia, Turkey and Armenia have current-account deficits and loan-deposit ratios of well over 100%. They are highly dependent on foreign money, and thus highly vulnerable, the report said.
In the event of a critical problem in the Chinese economy, UBS believes emerging market credibility will be eroded and that there will be little choice but for countries to increase risk premiums.