If you took an extended break from early June to now you might be wondering how Greece and China switched places.
Back then everyone was worried that Greece would be forced out of the euro, breaking up the largest economic area in the world. There were concerns about China’s slowing growth but little action in the markets to suggest a meltdown.
Then China’s stock market imploded, commodities were routed and the country rushed out state support measures to keep everything going and devalued its currency. Meanwhile, the Greek crisis quietened down after a third bailout was agreed.
China became the big threat to global economic stability. There’s a lot of fallout but it can all be grouped into three main channels — politics, markets and monetary policy — to transmit doom around the world.
One of the big things China had going for it was political stability. Investors like to be sure that there won’t be sudden swings in who runs the country and how they run it. But now a few cracks are appearing in President Xi Jinping’s grip on power.
He’s tried a few ambitious policies, notably a crackdown on corruption and ostentatious gift-giving and a rebalancing of China’s economy away from exporting cheap labour, but they’re beginning to come up against “unimaginably” fierce resistance, according to a strongly worded commentary carried by state media on Thursday.
“The in-depth reform touches the basic issue of reconfiguring the lifeblood of this enormous economy and is aimed at making it healthier,” the article said. “The scale of the resistance is beyond what could have been imagined.” If the ruling party is split on what decisions need to be made during a time of crisis, it doesn’t bode well. Just look at what a lack of a unified approach did for Greece. While finance ministers spent hours at all night meetings bickering over how to solve the debt crisis, the markets crumbled along with confidence in Europe’s political leaders.
At its core this is about the unravelling of a boom in cheap money, which has inflated the price of assets across the world and pushed bond investors into riskier and riskier deals as they look for decent returns.
This has pushed global investments to 30-year highs, as this graph from Macquarie shows:
It doesn’t take much to trigger panic in markets where prices are pushing higher than the long-term values of the assets. A Chinese slowdown coupled with an expected rate rise in the US might tip sentiment just enough for this to unravel.
And that’s beginning to happen in the bond markets, according to this chart, which shows money flowing out of debt investments in the last few months.
China has devalued its currency by around 3% to help prop itself up. This should stem the tide of money leaving its shores, by making it more expensive to exchange yuan for dollars.
The problem for the rest of the world is that this makes Chinese exports cheaper, forcing its competitors to follow suit and devalue as well. As prices fall, a “wave of deflation” will rattle around the world, according to Albert Edwards, Societe Generale’s uber-bear economist. This could cause corporate profits to drop in the US, leading to a recession. These devaluations, coupled with a possible rate increase in the US, could spell disaster:
We expect the acceleration of EM devaluations to send waves of deflation to the west to overwhelm already struggling corporate profitability and take us back into outright recession. As investors realise yet another recession beckons, without any normalisation of either interest rates or fiscal imbalances in this cycle, expect a financial market rout every bit as large as 2008.
The devaluations won’t stop here according to analysts from Barclays in a note today. They see a further 10% fall in the yuan relative to the dollar.
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