Friday 30 September 2016

Will China's crash trigger a new global recession?

The weak post-2008 recovery is nearly over. The Chinese market crash means trouble and we in Ireland will not be spared

Published 12/07/2015 | 02:30

'Even more worrying has been the response of the Chinese authorities to the crash'
'Even more worrying has been the response of the Chinese authorities to the crash'

The weak post-2008 recovery in the global economy is drawing to a close. Greece, China, falling bond and equity prices, all point to trouble ahead. With one of the world's most open economies, we in Ireland will be among the first to feel the draft.

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Following the stunning success of the "no" camp in last Sunday's referendum all eyes have been focused on Greece. Will the Mediterranean country be able to agree a package with its creditors that allows it to stay in the euro or is 'Grexit' finally upon us? If Greece does become the first country to exit the single currency what, if any, will be the consequences for the rest of the eurozone?

While the fate of Greece is not entirely irrelevant it should be borne in mind that, with annual GDP of less than €240bn - just over 2pc of the total eurozone economy - its capacity to damage the overall European economy is limited. Indeed the main threat from potential Grexit is almost certainly psychological rather than economic as nervous investors ask "who's next" in the wake of a Greek departure from the single currency.

Meanwhile, other developments with potentially far more serious implications for both the European and global economies have so far passed largely unnoticed.

Since mid-April, bond prices have fallen sharply. This is despite aggressive buying of eurozone government bonds by the ECB. This in turn has pushed up the yield, or interest rate, on those bonds. Higher bond yields will feed through into higher medium- and long-term interest rates for eurozone companies and households, including those in Ireland. With the Fed set to start pushing up short-term US interest rates from September, how will higher interest rates affect the global economy?

It isn't just bond prices that have been falling recently. Share prices have also been slipping with both of the major US indices, the S&P 500 and the Nasdaq, down about 4pc over the past month while in London the FTSE 100 has shed over 5pc of its value since the end of May.

Commodity prices have also been on the slide. Crude oil prices have fallen by 50pc over the past 13 months. The prices of other commodities including copper (down 20pc) and steel (down 80pc) have also fallen sharply in recent months as industrial users, mainly in China, scale back their orders in the expectation of lower demand from their customers.

Bond, share and commodity prices are generally leading indicators as investors seek to anticipate future events. The recent price falls show that most investors are now pessimistic about the future and are expecting an economic downturn if not a full-blown recession.

Writing to his shareholders last April, Jamie Dimon, the chairman of America's largest bank JP Morgan Chase, wrote that: "Some things never change - there will be another crisis, and its impact will be felt by the financial markets."

At the root of this pessimism is the fact that despite massive bond buying, so-called "quantitative easing" by all of the world's major leading central banks over the past seven years and record low interest rates, the recovery in the global economy since the 2008 crash has been a very shallow one. While US economic output has returned to pre-crash levels, this has yet to happen in the eurozone.

"Past deep recessions were typically followed by strong recoveries. This time the recovery has been insipid. The risk of near-zero inflation is that real debt increases, the real cost of borrowing rises and, ultimately, economies cannot recover on a sustainable basis," writes HSBC chief economist Stephen King.

Ironically some of the steps taken by central banks in the immediate aftermath of the 2008 crash, particularly slashing interest rates, have almost certainly contributed to the current global economic malaise.

"In all recessions since the 1970s, US interest rates have fallen by at least five percentage points. Now such traditional stimulus is ruled out," writes Mr King.

"When debt levels are low, interest rates are high and budget deficits are small, dealing with recessions is relatively easy, even if preventing them in the first place is problematic. When debt is high, interest rates are zero and budget deficits are large, dealing with recessions is much more troublesome."

Even quantitative easing has not been an unmixed blessing. All of this extra low-cost cash that has been created by central banks has to go somewhere.

"One solution is to push asset prices higher in the hope that debts become more willingly held, balance sheets look healthier and the pressure to deleverage is reduced. Quantitative easing has done precisely that, but the increase in asset values has not translated fully into decent economic growth or higher inflation."

However, the seemingly never-ending Greek crisis along with lower bond, share and commodity prices are no more than the economic equivalent of a nagging pain - unpleasant at the time but ultimately not life-threatening. In most cycles it is not such chronic aches and pains but one cataclysmic event, such as the failure of investment bank Lehman Brothers in September 2008, that finally pushes the world economy into recession.

Will recent events in China provide the push that leads to the next global recession? Unlike Greece, China is a major player in the international economy. Depending on how one does the numbers it is either the world largest or second-largest economy. Which is why we should all be very worried about what happens in China.

Over the past three weeks the value of shares on the Shanghai stock exchange, which had risen by 150pc over the previous 12 months, have fallen by 30pc while the even more speculative Shenzen exchange is down 42pc.

Even more worrying has been the response of the Chinese authorities to the crash. Instead of letting the market correction run its course, the Chinese regulatory authorities have banned short-selling, banned major shareholders from selling their shares for six months, effectively banned new IPOs and relaxed margin requirements. Has the conversion of the ruling Communist Party to capitalism been merely skin-deep?

If such a draconian response was supposed to steady the Chinese equity markets then it clearly hasn't worked. If anything it has had the opposite effect. Chinese share prices, which rose briefly at the beginning of last week after the announcement, quickly resumed their slide.

The share price crash and the response of the regulatory authorities have fuelled long-running fears about the real state of the Chinese economy. While investors are prepared to ignore a lot when prices are rising, it is a different story when they start to fall. What will they find when they start looking under the carpet?

Some indication of what they may discover was provided in a devastating 2013 presentation by Jim Chanos, the founder of hedge fund Kynikos and long-term China bear. In his presentation Mr Chanos pointed out that China has experienced an unprecedented investment boom over the past decade with gross fixed capital formation running at over 45pc of GDP. Such extraordinarily high levels of investment would inevitably lead to diminishing returns, he warned.

"Large scale capital projects grow sillier by the day," he said. Among the choicer examples highlighted by Mr Chanos were; the New South China Mall - the world's largest and loneliest; New Ordos - an empty city in Inner Mongolia; and Sky City One the world's tallest building, which was to be built in just 90 days.

Just for good measure 1,188 new shopping centres were scheduled for construction by 2015, 28 Chinese cities had been given the go-ahead to build new subway systems or expand existing ones and 26 new airports were due to open.

This investment boom has been accompanied by credit and asset price bubbles. Chinese bank lending has tripled to $26 trillion - the equivalent of 250pc of GDP - since 2007.

Apartments in Beijing are now almost three times as expensive as those in either London or New York when measured as a multiple of local salaries. Previous experience does not provide much room for optimism - 40pc of Chinese bank loans went sour when the 1990s boom turned to bust.

What condition are the Chinese banks in now, following their post-2008 lending sprees? How confident are foreign banks who lent $1.1 trillion to Chinese borrowers of ever getting it back?

Chinese unit labour costs are also rising sharply as the one-child policy begins to bite and the workforce starts to shrink. Chinese manufacturing wages have risen by an annual average of 14pc, a cumulative 146pc over the past seven years.

The "offshoring" phenomenon, of which China had been a major beneficiary, has now gone into reverse as some US companies have begun to repatriate manufacturing operations to take advantage of cheaper energy costs Stateside.

The crash and the authorities' response will also increase doubts about the accuracy of Chinese economic statistics. Year on year, even during the worst of the post-2008 downturn, China has cranked out annual GDP growth of 7.5pc. Mr Chanos cites a WikiLeaks cable in which a US diplomat quotes Chinese prime minister Li Keqiang as saying: "GDP figures are man-made and therefore unreliable."

HSBC's Mr King compares the world economy to a ship sailing Titanic-like across the ocean with a serious shortage of lifeboats. Will China prove to be the iceberg that sends the ship - and many of its passengers - to the bottom?

How will the Chinese crash affect Ireland's economy?

While Michael O’Leary finally accepted on Friday that he will now not take over Aer Lingus — when the announcement was made that Ryanair was willing to sell its shares to IAG — it was one of those special moments.

The low-fare airline’s colourful chief executive, who has been so outspoken on Aer Lingus over the years, could not resist pointing out the two airlines’ relative places in the pecking order.

“In late 2006 when Ryanair first bid for Aer Lingus, Ryanair with 36 million passengers carried four times the Aer Lingus traffic of nine million. Today Ryanair (with over 100 million passengers) carries more than 10 times the Aer Lingus traffic (of 10 million). And we will continue to deliver the vast majority of Ireland’s traffic and tourism growth in the coming months and years,” he said.

The news that the board of Ryanair has voted unanimously to accept IAG’s €2.55 per share offer, valuing the former state airline at €1.36bn, brings to an end one of the most protracted takeover bids in Irish business history.

The news leaves the way clear for the deal to be approved by the EU Competition Authority and for IAG to begin its takeover of Aer Lingus at the EGM on July 16. It will mean that both Ryanair and Aer Lingus will be in a position to focus on their core businesses — which will ultimately be good for them both, according  to David Holohan, head of research at stockbroking firm Merrion.

“This brings a rather quiet end to quite a tumultuous relationship between Ryanair and Aer Lingus. And while Ryanair has made a quite modest profit — given what they have put into purchasing Aer Lingus shares over the last nine years, and receiving about €400m once the deal completes — it may be a disappointment for Michael O’Leary personally as he had very big plans for Aer Lingus under Ryanair’s ownership,” he said.

Whatever the disappointment for Michael O’Leary personally, an end to the nine-year attempt to take over Aer Lingus may come as a relief to other senior executives and staff at Ryanair.

Many industry insiders believe that the protracted takeover deal took focus away from Ryanair’s core business and it may not be a coincidence that Ryanair’s ‘Always Getting Better’ plan, which has seen the company soar to new heights, commenced once it became apparent that Ryanair would not be permitted to take over at Aer Lingus.

This refocus of the business model has seen Ryanair’s full-year profits up 66pc with passenger numbers up 11pc in the same period.

It’s an analysis that Holohan broadly agrees with.

“For Ryanair as a whole, I think it served as a distraction from their overall growth ambitions, which are much, much bigger than Aer Lingus’s could ever have been,” he said.

The €400m may be a welcome addition to the company’s cash reserve - but it is unlikely to make much of an impact on year-end results. Such is the scale of Ryanair that the amount it will receive in cash and dividends from IAG isn’t the boon that it would be for most companies.

Ryanair declined to comment on what its plans were for the cash it will receive in return for its Aer Lingus shares, but it raises the possibility of some generosity in terms of share buyback and dividends, which have become more common in recent years.

Holohan believes that ultimately the deal is good for both parties in the separation. Aer Lingus, he believes, will benefit from being part of a much larger airline network, and will relish the possibility not just of competing against Ryanair for the first time in almost two decades, but also growing its long-haul business out of Ireland.

“It is also good from an Aer Lingus perspective, being part of a much bigger airline group is a very positive move for them. They will now be able to offer significantly more destinations through the IAG network than they simply would be as a standalone,” Holohan said.

While O’Leary may have finally accepted that he will not takeover Aer Lingus, the airline industry’s original big personality — Virgin boss Richard Branson — is unlikely to be happy with the news that IAG is now set to takeover Aer Lingus.

Earlier this year Branson said that he found it “incredible that the competition authorities allow such things to happen”.

While Branson may rankle that IAG, who already dwarf Virgin Atlantic’s presence at Heathrow are set to add even more slots to their roster, it now looks inevitable that the EU’s Competition Authority will rule positively on the deal next week.

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