People on Wall Street are talking about China like it has a disease they don't want to catch

Wall Street talking about China like it has a disease — deflation — and is about to pass it onto the rest of the world.
It’s an issue that comes up with China from time to time, and has two parts.
As China’s economy goes through the painful transition from an investment-based economy to one based on consumer spending, its demand for materials — especially commodities — that it once consumed in great volume will decrease, suppressing prices and hurting commodity sellers.

Also, to smooth out the transition China will allow its currency to decline in order to sell more goods abroad and solve its problems with overcapacity. This, in turn, could spark other countries to do the same thing.

This is an accusation China’s leaders have taken pains deny in the past. Last March China’s Premier, Li Keqiang, who is responsible for the country’s economy, said in no uncertain terms that China isn’t exporting deflation to the rest of the world.

But things have changed since then, especially now that the country is allowing its currency to depreciate in a controlled manner. All of the sudden all of Wall Street is either rallying to China’s defence or accusing it of poisoning the global well. All of the sudden this ‘exporting deflation’ theory isn’t being relegated to known bears and bubble-watchers — it’s dominating a conversation.

This weekend, China bull Torsten Slock addressed the accusation directly in a note called ‘Is China Exporting Deflation?’ First off, he reminded his readers that a China slow down would do little to U.S. or European GDP.

He also said that concerns about this are “overblown” because the volatility we’ve seen so far this year — a few Chinese stock market crashes and a currency devaluation — don’t translate into the real economy.

“…the disconnect between China’s stock market and the real economy, the currency move is probably not a precursor to a major devaluation and there are signs of improvement in the residential property market. Indeed, our outlook for Chinese growth is unchanged at 7% for this year,” Slock wrote.

(The country’s GDP came in at 6.9% for 2015 — a figure many on Wall Street question.)

So nothing to see here, right?

A lot of economists would say, wrong. Why? Because China’s impact with the U.S. and Europe aside, where Slock says that the yuan’s downward move isn’t the beginning of anything major, others disagree strongly.

In play

That is because since the beginning of the year the yuan has become one big question mark.

Celebrated China analyst Charlene Chu wrote earlier this year that, as the Chinese government runs out of good options to stimulate the economy, the yuan is now more part of their “playbook.”

“In our view, a much larger move [in the yuan] than 2015’s 4.6% is likely over 2016-17, the size and timing of which will be driven by the degree of capital outflows and extent of deceleration in GDP growth,” Chu wrote.

Combine that with what Oxford associate professor George Magnus, has said about what a declining yuan is already doing to the world. Emerging and developing markets, which make up 40% of global GDP, are already hurting thanks to China’s slow down, a cheap yuan would only make that worse.

“A Yuan devaluation would almost certainly be reflected in further across-the-board US dollar appreciation bringing new financial stress to both commodity producers, and to non-financial companies that have borrowed in US dollars,” Magmus wrote in Prospect Magazine earlier this month. “Both topics have figured prominently on the IMF’s financial instability watch-list for some time.”

In other words, a falling yuan sets off the second deflationary trigger as the world starts to handle Chinese overcapacity.

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