Wednesday 21 March 2018

China threatens global recovery

As the financial turmoil in China drags on, fears of a new worldwide economic recession are mounting, writes Dan White

Asian stocks
Asian stocks
Dan White

Dan White

The great fall of China goes on. Last week share prices fell by a further 16pc on the Shanghai stock market, China's main equity market, and by 19pc on the more speculative Shenzhen market.

Despite the imposition of draconian restrictions on share sales, a de facto currency devaluation, interest rates cuts and unprecedented market intervention by the Chinese authorities, Shanghai share prices are now down by 40pc on their June peak while Shenzhen prices have fallen by almost 45pc over the same period.

None of the usual policy quick fixes seem to be working.

The longer this goes on, the less like a temporary market correction and more like the start of something more serious, it begins to look. Last week the ripple effects spread outwards with crude oil prices falling to a six-year low and turmoil on the foreign exchange markets. Share prices on other Asian stock markets also fell sharply as investors priced in the impact of a possible Chinese slowdown on other economies in the region.

So just how worried should we be by what is happening in China?

One probable casualty of last week's market turbulence looks like being an increase in US interest rates, the first for nine years, which Fed chairwoman Janet Yellen had clearly indicated was being planned for next month. That now looks very unlikely.

William Dudley, president of the New York Federal Reserve, was quoted as saying last week that: "At this moment the decision to begin the normalisation process [raise rates] at the September meeting seems less compelling to me than it did several weeks ago".

Was Mr Dudley merely speaking for himself - or was he, the boss of the Fed's most important constituent bank, sending a signal on behalf of Ms Yellen? Currency traders, who sold the dollar, seemed to think the latter.

Meanwhile investment bank Goldman Sachs was oozing reassurance. In a note to clients on Tuesday, analyst Peter Oppenheimer wrote that: "The drop in commodity prices during the past year and recent economic and foreign exchange weakness in China and other emerging markets will not tip the global economy into recession."

So what about the collapse in global commodity prices - with crude oil having fallen by over 30pc, copper by 17pc and steel by 50pc over the past three months? The basket of global commodity prices is back to 1999 levels.

"Our commodity strategists have long argued that the negative price moves in oil and commodities were primarily a reflection of excess supply as opposed to inadequate demand," wrote Mr Oppenheimer.

Deutsche Bank foreign exchange strategist George Saravelos is considerably less sanguine about the impact of the Chinese turmoil on the global economy. He points to the huge foreign currency reserves accumulated by China in recent years - more than €3.55bn.

This process of reserve accumulation in which the Chinese central bank - the People's Bank of China - essentially created domestic currency that it used to buy foreign bonds, principally US Treasuries, amounted to a huge injection of liquidity into the global economy.

Mr Saravelos calculates that Chinese bond purchases since 2003 exceeded the Fed's post-2008 quantitative easing and have been one of the main contributors to low bond yields worldwide.

Now this process has gone into reverse.

As doubts about the future prospects of the Chinese economy have increased, capital has been fleeing the country. Capital flight from China is now running at up to $200bn a month forcing the PBoC to sell foreign bonds to prop up the value of the Renminbi.

"The PBoC's actions are equivalent to an unwind of QE - in other words, quantitative tightening (QT)", he writes. "It is hard to be very optimistic on global risk appetite until a solution is found to China's evolving QT".

In other words, while the recent turbulence in the Chinese stock markets may have taken the prospect of an immediate increase in US interest rates off the table, a reversal of - or even a halt to - China's accumulation of foreign reserves would exert upward pressure on American interest rates.

China owned $1.27 trillion of Treasuries at the end of June, almost 10pc of the total US government debt market.

Citigroup chief economist Willem Buiter, a former member of the Bank of England's interest rate-setting Monetary Policy Committee, believes China is sliding into a recession, dragging the rest of the world economy down with it - and that the country's authorities won't respond quickly enough to stop it happening.

In common with many external analysts, Mr Buiter believes that the Chinese economy is dangerously skewed towards investment, with over 50pc of GDP going on investment and only 28pc on consumption.

In a "normal" economy these percentages would be reversed. This over-reliance on investment is now a large part of the problem.

Mr Buiter recommends that the Chinese authorities unleash a consumption-orientated fiscal stimulus programme to head off the threat of recession - but he doubts that they will do enough or do it in time.

"They will respond, but they will respond too late to avoid a recession, which is likely to drag the global economy with it down to a global growth rate below 2pc - which is in my definition a global recession."

Jim Chanos, founder of $6bn hedge fund Kynikos and long-term China bear, has also been trowelling on the pessimism. "China is worse than you think. Whatever you might think, it's worse," he said. "People are beginning to realise the Chinese government is not omnipotent and omniscient. In fact, like many of us, sometimes they don't have a clue."

Mr Chanos also believes that a Chinese slowdown will have implications for the global economy. Particularly vulnerable are those companies that bet big on the Chinese market. Among the companies Mr Chanos has short sold are oil firms Chevron and Shell, solar energy provider SolarCity, technology giant Hewlett-Packard and construction equipment manufacturer Caterpillar.

Apple, the world's most valuable company, relies on the Chinese market for over a quarter of its sales. It too has felt the chill wind blowing from the east with its share price down almost 20pc over the past three months.

At root, the Chinese problem is one of debt.

The exports from its factories have pumped out the cheap exports that have slashed the price of the consumer goods we all crave. The China phenomenon, which has seen a previously dirt-poor country grow to become the world's second-largest economy in the space of a quarter of a century, means that the price of everything from mobile phones to furniture now costs a fraction in real terms of what it did a generation ago.

Unfortunately, much this growth seems to have been funded by debt, with total Chinese borrowing - both public and private - now standing at an estimated US$22 trillion, or almost 300pc of GDP.

While the investment-led economic model pursued by China since the early 1990s has delivered unprecedented economic growth, lifting hundreds of millions of Chinese out of poverty in the process, there are clear signs that it is now running out of steam.

This message has yet to get through to the Communist Party. It is still determined to achieve the 7pc annual economic growth rates which now seem to be its sole raison d'etre. Not alone does this reinforce existing scepticism about the accuracy of Chinese economic statistics, it also encourages further ill-thought-out investment projects - roads to nowhere, 'ghost cities', even more steel mills - that will make the eventual reckoning even more painful.

So can China wean itself off its investment addiction and make the transition to a consumption-led economy, or is the Communist Party incapable of managing the change? If Goldman's Mr Oppenheimer is right, then the worst may already be over and the global economy will be spared a recession.

While the raft of emergency measures taken by the Chinese authorities to deal with the immediate crisis may well buy some time, with Shanghai share prices up strongly on Friday, they don't address the underlying issue. Instead the Communist Party has ducked the challenge with total Chinese borrowings almost tripling since 2008 as the investment-led economic model has gone into overdrive.

As we in Ireland know only too well from bitter experience, cooling down an over-heating economy is an extremely difficult challenge. Soft landings are easier to talk about in theory than to achieve in practice. Will it be any different in China? We in the west can only hope that the optimists such as Mr Oppenheimer are correct - but we should be preparing for the worst.

Sharing the pain

So what does a possible Chinese slowdown mean for us in Ireland?

While our trade with China represents just 6pc of our total foreign trade, we in this country will not be immune to a slowdown in the world's second-largest economy.

In 2014, total Irish exports to China were worth €2.1bn, or just over 2pc of our total €89bn of goods exports last year. We imported almost €3.5bn of goods from China, 6.5pc of our total imports.

So with less than 4pc of our total foreign trade being with China, do we have anything to fear?

We shouldn't be so blasé about a Chinese downturn. Not only would a serious Chinese recession have knock-on effects on the global economy, to which we are very exposed, but also the bald trade statistics almost certainly understate our true reliance on the Chinese market.

As this year's collapse in dairy prices demonstrates, we in Ireland are far more dependent on the Chinese market than we might have previously imagined. China is now the largest export market for Irish food products outside the EU. Irish farmers and food processors had been relying on China for the growth they could no longer achieve in the mature UK and mainland European markets.

However, what is bad news for our farmers and food processors might be good(ish) news for Irish consumers. The post-2008 investment binge has left China with enormous surplus production capacity in just about every market segment. Allied to the fact that China has abandoned the renminbi's dollar peg and effectively devalued its currency, this is likely to result in a deluge of cheaper consumer goods in the months and years ahead as Chinese producers seek markets for all of this new capacity coming on stream.

So it's good news for consumers - so long as their employer isn't competing with Chinese producers.

Sunday Indo Business

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