How the Coronavirus Outbreak Could Trigger a China Meltdown — and What to Watch

By: TradeSmith Research Team

4 weeks ago | News

The China coronavirus outbreak continues to worsen:

  • The death toll in China is 170 as of January 2020, with more than 7,700 infected within China.
  • In the United States, the Centers for Disease Control and Prevention (CDC) has confirmed a person-to-person transmission on American soil. Taiwan, Vietnam, Japan, and possibly Hong Kong have reported person-to-person transmissions.
  • The World Health Organization (WHO) is debating whether to officially declare an international public health emergency.
  • As a preventive measure, Russia is closing off its land border with China, a massive distance that spans 2,670 miles.
  • China’s currency, the renminbi (RMB), has weakened below the critical seven-per-dollar threshold on rising economic fears, as supply-chain links are cut off and flights in and out of China are canceled.

As coronavirus problems intensify, the hit to China’s economy grows worse. Nobody knows how quickly China’s economy can bounce back from this — or whether it can bounce back at all, versus slipping into a downturn or recession.

For comparative reference, investors are looking at what happened with the China SARS outbreak nearly 20 years ago in the 2002-2003 period. But China had a far smaller economy back then, with far fewer supply-chain links and far less debt.

Based on the official numbers, China has not had a recession in decades. That kind of streak is not unheard of — Australia has gone without a recession for 28 years, in part because they sell natural resources to growth-addicted China.

But the looming questions are:

  • What happens when China’s downturn and recession finally arrives — as eventually it must?
  • What happens to China’s markets for housing, construction, and consumer financial products, all of which are built on staggering amounts of leverage and debt?

From an outside point of view, China’s economy is a black box. China’s economic numbers are widely viewed as manipulated by the government. But it’s possible to get a sense of how fast China’s economy is growing by looking at alternative data measures that are harder to fake, like levels of electricity use.

And it is clear China’s political leaders need to maintain economic growth and credit growth, almost no matter what, in order to stave off severe downturn risks.

This is what makes the outbreak a huge issue for markets: Looking beyond the short-term global economic hit, and beyond the human suffering, to crisis-level consequences for China itself.

If the coronavirus is enough of a “black swan” event — a surprise nobody expected — to put China into recession and incite mass civil unrest, it could trigger a series of internal debt defaults and financial product blow-ups that lead to a full-scale economic collapse, a collapse of the currency, or both.

You never hear much about financial turmoil inside China because the government covers it up. In this manner, China can quietly absorb tremendous amounts of financial volatility. But China’s authoritarian system has vulnerabilities: China’s economy is connected to the outside world through business and commerce links; Chinese consumers have personal exposure to trillions of dollars’ worth of real estate and financial derivative products; and China’s leaders, like all authoritarian leaders, are wary of civil unrest.

Against extraordinary vulnerability, government bailouts can only go so far. The Chinese government can prop things up at the margins with checks payable in fiat currency. But if the hit is large enough and sudden enough, the damage could snowball too quickly to be controlled.

If this happened, we would likely see evidence by way of a collapse in China’s currency, as China’s central bank printed up massive amounts of RMB to cover a run of bailouts. That currency collapse, in turn, would send shockwaves all throughout the global economy.

Then, too, the coronavirus is already stirring up notable civil unrest within China.

The Chinese city of Wuhan is ground zero for the outbreak. When the mayor of Wuhan was forced to resign — shamed by the public for the plodding slowness of the city’s response — he passed the blame to China’s central government, suggesting the weeks-long delay came on Beijing’s orders. 

The Chinese people are increasingly angry, furious even, with the government’s tendency to suppress information, delay public announcements, and otherwise keep the citizenry in the dark as to the true nature of problems.

A hesitancy to share information is a mark of all authoritarian regimes. Because the coronavirus is a national health emergency, it reflects extremely poorly on President Xi Jinping’s leadership — and anger is rising rapidly within China. If the coronavirus fallout grows worse, the dystopian scenes we’ve grown used to in Hong Kong could spread to the Chinese mainland. 

For the global economy, the impact of the coronavirus outbreak is a “known unknown.”

Meaning, we don’t know how bad the global economic hit will be. But investors at least know the question. They have it on their radar screens — with many optimistic that business will bounce back quickly.

What happens to China’s economy and the current political leadership, however, is an “unknown unknown.” On this front, the coronavirus could fuel outcomes that are far more serious.

And yet, investors seem not at all aware that China’s whole growth boom could be at risk, or that China’s economy could implode, causing China’s currency to collapse alongside, or even that the Chinese Communist Party (CCP), which has ruled China for decades, could now be in serious trouble. 

Along with coronavirus news and civil unrest reports, the thing to watch is the renminbi. Breaking the critical threshold of seven RMB per dollar is an early warning sign.

If China’s currency weakens further, or goes into freefall, the implications will be ominous.

TradeSmith Research Team

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