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Goldman says investors overreacting to China creates problems

The problem with China isn't just a slowdown, it's investors freaking out over it, according to a new report by Goldman Sachs Group Inc.

[NEW YORK] The problem with China isn't just a slowdown, it's investors freaking out over it, according to a new report by Goldman Sachs Group Inc.

"We believe that developed financial markets will, in all likelihood, overreact to deteriorating conditions in China," a team led by Sharmin Mossavar-Rahmani, chief investment officer at Goldman Sachs Private Wealth Management, wrote in a paper.

"We conclude that the direct and indirect economic and banking sector exposures to China are not of a scale to have significant impact on major economies and financial markets."

What to do? It's hard to tell markets to be calm about concerns over the world's second-biggest economy. China faces myriad challenges, from corruption to unreliable economic data, and Goldman Sachs expects the country to create volatility for the next five years, infecting other emerging markets. Their recommendation is to reduce exposure to these vulnerable assets.

China did not start 2016 on the right foot - for example, the decision to implement then abandon a controversial stock circuit-breaker system - and more mishaps are likely.

"Moreover, as evidenced by the measures taken to manage the equity and currency markets over the last several months, the risk of policy mistakes looms large," according to the report, entitled "Walled in: China's Great Dilemma."

Goldman Sachs's investment management team showed how the impact of slower growth in China on the global economy has been "overstated" by charting exports as a share of gross domestic product. In the US, exports to China account for just 0.7 per cent of GDP. It is 2.3 per cent for emerging markets, and as high as 10.3 per cent in South Korea.

China has shaken investor confidence with surprise currency moves and confused with chaotic market regulation. Chinese Vice President Li Yuanchao told Bloomberg in Davos this week that authorities are willing to keep intervening in the stock market to make sure that a few speculators don't benefit at the expense of regular investors.

Goldman Sachs predicts the yuan, also known as renminbi, will depreciate between 10 per cent and 20 per cent over the next two years: "Of course, the renminbi could weaken further by 2020, especially if the depreciation were to become disorderly, or if the capital account is opened up and China witnesses significant capital outflows."

Turning to growth, Goldman Sachs says China is likely to reach its 6.5 per cent minimum growth target in two to three years and have adequate resources to avert a so-called hard landing in 2016. In the long run, however, the outlook is somewhat grimmer.

After two decades of record-breaking growth, the world's most populous nation risks the fate of neighboring Japan: an extended period of slow growth and possibly deflation.

"China would be entering the slowdown from a much weaker starting point than Japan when it entered its lost decades," the report warns.

"China is poorer, has less favorable demographics, suffers from weaker human capital factors, is more dependent on investments and ranks lower on business environment indicators."