Analysis: China's market Leninism turns dangerous for the world
The world financial system is at a dangerous juncture. Markets no longer believe that China’s Communist leaders are in full control of the country’s $27 trillion debt bubble, or know how to manage fast-moving events beyond their ken.
This sudden loss of confidence in the anchor economy of East Asia has struck before the West is fully back on its feet after its own debacle seven years ago.
Interest rates are still near zero in the US, the eurozone, Britain and Japan. Fiscal deficits are at unsafe levels. Debt is 30 percentage points of GDP higher than it was at the onset of the Lehman crisis. The safety buffers are largely exhausted.
“This could be the early stage of a very serious situation,” said Larry Summers, the former US Treasury Secretary. He compared it to the two spasms of the Asian crisis in the summer of 1997 and again in August 1998.
Ominously, he also compared it to the "heart attack" of August 2007, when credit markets seized up on both sides of the Atlantic and three-month US Treasury yields plummeted to zero. That proved to be a false alarm, but it was an early warning of the accumulating stress that would bring down Western finance a year later.
Full-blown contagion is now ripping through the international system. The main equity indexes in Europe and the US have all sliced through key levels of technical support.
Once the S&P 500 index on Wall Street broke below its 200-day and 50-week moving averages last week, it was extremely vulnerable to any bad news. This came last Friday with yet more grim manufacturing data from China.
JP Morgan says the Caixin PMI indicator that so alarmed markets is skewed to the weakest segment of the Chinese economy and overstates the trouble, but such subtleties are lost in a panic.
It turned into a global rout after the Shanghai composite index crashed 8.5pc on China’s “Black Monday”, pulverizing its July lows after the central bank (PBOC) - oddly passive - refused to come to the rescue as expected with a cut in the reserve requirement ratio for banks.
Beijing’s botched efforts to prop up the country’s stock markets have collapsed. An estimated $300bn of state-orchestrated buying achieved nothing, overwhelmed by an avalanche of selling by investors forced to cover margin debt.
Professor Christopher Balding from Peking University wrote on FT Alphaville that China is lurching from one incoherent policy to another, shedding credibility and its aura of omnipotence at every stage. “There is a very real risk that Beijing is losing control of the story,” he said.
The speed with which this episode has now engulfed US markets - trading at 50pc above their historic average on the long-term Shiller price/earnings ratio, and primed for trouble – suggests that events could all too easily metastasize into a self-perpetuating crisis of confidence. The Dow may have rebounded after a record 1,090-point drop at the opening bell, but such tremors cannot be ignored.
“Circuit-breakers are needed, given how quickly markets have moved. Crises are highly non-linear events and ruling them out isn’t wise,” said Manoj Pradhan from Morgan Stanley.
The question is whether China’s economy will itself prove to be the circuit-breaker by confounding the predictions of economic meltdown. There are signs that growth is poised to pick up after a deep slump in the first half of the year, caused by a combined monetary and fiscal crunch.
Spending contracted 19.9pc in January as local government reform went horribly wrong. It did not recover fully until May and June, when the new bond market took off. The fiscal stimulus will feed through over the next six months.
Simon Ward from Henderson Global Investors says his measure of China’s money supply – “true M1” – turned negative late last year for the first time this century. It has since recovered briskly and is growing at a 10pc rate, implying a recovery of sorts a few months later.
The Shanghai equity collapse has been spectacular, but the number of shares in private hands amounts to just 30pc of GDP, compared to 81pc on Wall Street in 1929 and 183pc in 2000.
The wealth effects are limited. “Only one in 30 Chinese owns equities. We think the authorities should just let the chips fall where they may,” said Mark Williams, chief Asia strategist for Capital Economics.
Property is far more important. Home ownership rates are almost 80pc in China and the housing market is recovering, with prices rising 6.5pc in the big Tier 1 cities over the past year and finally bottoming out in the regions.
Yet what began two weeks ago as a technical move by the PBOC to end China’s dollar exchange peg, and switch to a managed float, has set off a global crisis with a life of its own that cannot easily be reeled in.
The PBOC’s move was widely seen to be the start of a devaluation push that would transmit a deflationary shock through East Asia and the rest of the world.
China is burning through foreign reserves at a blistering pace to stabilize the yuan and offset capital flight estimated at $35bn a week. This is automatically tightening monetary policy, squeezing liquidity, and risks holding back the very recovery in China needed to quell doubts.
Whether or not China’s economy is as weak as feared, the crisis is feeding a global chain-reaction through the entire nexus of emerging markets (EM), now half the global economy and therefore a greater threat than in the previous EM crises of the early 1980s and the late 1990s. “We are seeing the worst of all storms for emerging market currencies,” said Bernd Berg from Societe Generale.
“This crisis has the potential to become worse than the Asian crisis in 1997/98 as it is spreading globally. Panic selling is triggering a bloodbath among EM currencies,” he said.
The 1998 Asian crisis did not lead to a global recession. The US and European economies brushed it off in the end. Markets raced on for another two years.
Yet it felt deeply threatening at the time. The Russian default triggered the collapse of the huge US hedge fund Long Term Capital Management, forcing the New York Fed to intervene to avert a systemic meltdown. The US slashed interest rates.
The Fed cannot cut rates this time, but it can issue a clear signal that it plans to delay rate rises. The futures markets are already pricing this in, slashing the chance of a rise in September to just 24pc, down from 50pc on Thursday.
The dollar is already weakening against the euro and the yen. Once the dust settles, this should take some of the sting out of the EM crisis, deferring the day of reckoning for companies in Latin America, Turkey, China, and other emerging regions holding an estimated $4.5 trillion of US dollar debt.
The violent moves over recent days may prove to be no more than an August squall. “Liquidity has dried up over the summer and that has exaggerated the moves,” said Marc Ostwald from ADM.
“The consensus trades are getting blown up and we are seeing an unwinding of carry trades as people get stopped out of positions. But credit stress is not that high by historical standards,” he said.
The economies in Europe and the US are lacklustre but recovering gradually. China may, in reality, be on the cusp of another upward mini-cycle, the latest in a string of stop-go episodes.
What is clear is that the world is no longer willing to give the economic benefit of the doubt to Chinese leaders. The pretensions of market Leninism have been shattered by one policy blunder after another over the past year.
Global markets have swung almost overnight from a mystical faith in the competence of the Communist Party to near revulsion, doubting everything until proven. From now on, Beijing is on probation.