Editors' Pick: Originally published Dec. 28.
China faces a "sudden stop" in its economy in 2016, as the government loses its ability to prop up state-subsidized industries and capital flight prompts a significant devaluation of the country's yuan, according to the analyst who accurately forecast Russia's stock-market crash in 1998.
JP Smith, who worked at Deutsche Bank before leaving last year to start independent research firm Ecstrat, says conditions in China look as ominous as those in the U.S. on the eve of the 2008 financial crisis, and in Korea just before the 1997 Asian crisis. As a result, Chinese stocks face greater downside potential than those of any other global market, he wrote in a Dec. 17 report.
The projection contrasts with the outlooks of many investors and analysts who are betting China's economy is on track for a gentle slowdown. Bank of America predicted in a report this month that the country will undergo a gradual currency devaluation as it shifts to a services-based economy.
Market forces probably will trump Chinese authorities' ability to control the economy and capital flows through official dictates, according to Smith.
"Companies across a number of key industries appear to be on the verge of a liquidity crisis, while the efficacy of repeated monetary and fiscal stimulus measures appears to be diminishing," Smith wrote. "It is clear that the underlying pressure for capital to leave China is likely to increase further over 2016."
A sharp downturn in Chinese stocks would mark a departure from this year, when the nation's equity market held up better than those of counterparts as authorities took steps to prop up share prices. The iShares MSCI China ETF (MCHI - Get Report) is down 6.3% this year, compared with a decline of 13% for a broader gauge of emerging-market stocks.
Bank of America said in a report that its forecasts for China "suggest a soft landing toward slower growth." The economy will grow by 6.6% in 2016, slightly lower than this year's estimated growth of 6.9% growth, according to the bank.
So far, China has been deploying its foreign reserves to support the yuan, which is pegged to a basket of foreign currencies including the U.S. dollar. According to Trading Economics, China's foreign reserves fell by $87 billion in November to $3.43 trillion, the lowest in almost three years. They're down from $3.99 trillion in June 2014.
China sent global markets reeling in August, when, in a surprise move, the country devalued its currency by almost 2%, the most in two decades. Not only did the move send a signal to investors that China's slowdown might be deeper than many economists realized, but it put pressure on other Asian countries to weaken their currencies so their manufacturers could remain competitive.
China chose to weaken its currency as speculation about a Federal Reserve interest-rate increase strengthened the U.S. dollar, a key piece of the country's currency peg. That had pushed up the value of the yuan and was crimping exports.
It's too early, meanwhile, to see the impact of the International Monetary Fund's approval this year of a plan for the tender to be included in a special basket of global reserve currencies; some analysts have predicted that the IMF's decision would prompt trillions of dollars of investment to flow into yuan-denominated assets.
According to Smith, there are questions on whether China even has its entire reserves available to defend the currency. For example, he says, the country's central bank has $1 trillion to $1.5 trillion of potential foreign-exchange liabilities, consisting of "inflows to debt and equity markets, carry trades and deposits and loans from overseas."
While the government might favor some depreciation to aid exporters, such a move could be exacerbated by capital flight, Smith says.
The pressure would come from investors trying to get out ahead of a devaluation. Many wealthy Chinese are trying to move their money abroad -- because of the prospect for diminished returns domestically as well as an increasing risk of government-led corruption investigations.
"Any aggressive intervention to shore up the currency by selling dollars from the FX reserves will tighten domestic liquidity and therefore risk exacerbating the very conditions that have brought about capital flight in the first place, thereby triggering a vicious circle," Smith wrote.
The entire picture is clouded by dubious statistics and government-led bailouts of companies in shady and barely-disclosed transactions, according to Smith. He estimates that banks are carrying bad loans at a rate of about 15% of the total, versus the stated 1.5%. It all looks pretty unsustainable -- just like the debt buildup in mortgages and mortgage-backed securities in the years before the U.S. financial crisis.
"Beijing's entire economic strategy has been based on a relationship of 'extend and pretend' between the financial and enterprise sectors," Smith wrote. When and if it comes undone, there's likely to be "collateral damage on the rest of the economy, far in excess of even the majority of the most pessimistic predictions."