All eyes will be on Federal Reserve Chairman Ben Bernanke today as he testifies before the Senate Banking Committee.
Since May, no macro topic has received more attention than the prospect of the Fed tapering its monthly purchases of $85 billion worth of bonds, which have helped keep long-term interest rates low around the world.
But in a new note to clients, Societe Generale’s Albert Edwards warns there is a much bigger macro story developing in China: the prospect of deflation.
Perhaps, though, the most decisive macro factor for all markets will be any slide into deflation in China. Certainly many see this as conceptually possible because of Chinas heavy over-investment. But is this fear now turning into reality? The recent Q2 GDP data contains the surprising fact that Chinas implicit GDP deflator had slowed to only 0.5% yoy noticeably weaker than the CPI data. This massive data point has gone virtually unnoticed in the markets (although it was pointed out by our own Wei Yao). The fact that China is on the verge of outright deflation may prove more important than even Fed tapering.
China is the world’s second largest economy, and it is one of the last few beacons of economic growth. So the prospect of falling prices would certainly have ripples around the world.
Part of the reason for this, Edwards argues, is the unsupported strength of China’s currency.
In addition to the usual argument that Chinas over-investment risks triggering deflation, we believe that this is also partly caused by currency dynamics. We identify China as suffering from excessive currency strength relative to regional competitors, both in nominal, and most especially, in real terms as wage inflation ripped upwards a few years back).
As we noted in a recent weekly, Japan’s devaluation has put additional stress on China. This reminds me very much of the events leading up to the mid-1990s Asian crisis. Of all the major currencies around the world, I struggle to find one that is suffering more from currency strength than China. Given that it is already struggling to restrain excessive credit growth, deflation and excess currency strength is one problem China can certainly do without.
The rise in Chinas real exchange rate in recent years is far in excess of the nominal advance. Chinese authorities almost actively encouraged rapid wage inflation in 2010-11 in an attempt to curtail worker unrest as food prices surged and The Arab Spring saw regime change on the north African coast. In addition, more recently, being tied to the US dollar at a time of dollar strength is exacerbating the squeeze on Chinas competitiveness and is undoubtedly hurting export growth.
Edwards repeated his 2011 thesis that the idea of the BRICs (Brazil, Russia, India, China) was actually a “Bloody Ridiculous Investment Concept.”
“The story of superior growth for the EM universe is as entirely plausible as it is misleading,” said Edwards. “Valuation is what matters for investing in EM, not their superior growth story.”
Indeed, despite the higher GDP growth, Emerging Market stock returns have been just dismal.
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