Posted on 14 August 2015
"The scale of the yuan decline seen so far looks significant relative to its own history, but is so far likely insufficient to move the dial for either China or the wider world economy."
“I watched a snail crawl along the edge of a straight razor. That’s my dream; that’s my nightmare. Crawling, slithering, along the edge of a straight razor… and surviving.” – Colonel Kurtz
Is China in trouble?
This was very much the question on investors’ lips this week. The long anticipated collapse in the Chinese economy seemed one large step closer to many this week after Chinese policymakers allowed the yuan (Chinese currency) to weaken materially (by its own artificially sedate standards). The move reverberated across global capital markets as traders bet that this would see a wave of China, and wider emerging markets brewed deflation, hit the developed world. Developed government bond yields fell across the curve, precious metals found some support and equities sold off as forecasters grappled with the implications for growth, inflation and the path of interest rates in the US economy. One famously perennial doom-monger has declared that China’s move heralds the end of the current economic cycle for the world economy.
Many readers will be understandably wondering how and why a low single-digit percentage movement in China’s currency provoked such instantaneous and widespread hysteria?
For those who have spent much of the last few years predicting a Chinese economic apocalypse, this new policy direction from the Chinese authorities gratifyingly suggests that the economy is in much worse shape than the widely disbelieved official statistics would imply. Many point to continuing declines in freight volumes, electricity consumption and commodity prices as further evidence, suggesting that the move in the yuan represents the opening shot in an emerging markets currency war that will unleash a wave of deflation on the developed world. For some, the resulting US dollar strength will snuff out the US economy, the lone bright spot in a world otherwise characterised by excessive leverage, low and falling growth and few further levers left for the central bankers to pull.
A less apocalyptic scenario…
There is no debate over whether the Chinese economy is slowing. It is whether this slowdown is measured or something more chaotic that is key to try and answer. We’ve devoted several recent articles to the rebalancing of the Chinese economy and pointed out that a lot of the statistics that many China watchers lean most heavily on may just not be able to bear the weight. Electricity consumption, freight volumes, commodity prices all likely speak more eloquently of conditions within the waning heavy industry segment of the economy, rather than the services economy which the authorities have been trying to promote. It may also be worth recognising that first half data may have been warped a little by the much needed efforts to restructure local government finances – delayed details of the municipal bond programme, aimed at facilitating this restructuring, caused spending to freeze during the first part of this year.
For us, this week’s drop in the yuan is still probably best seen in the context of the near 10% appreciation in China’s real effective exchange rate1 over the last year, dragged unwillingly higher by the loosening peg to the dollar. A freely-traded currency may well have declined over this period given China’s increasingly visible slowdown and loosening monetary policy.
That the Chinese authorities chose this week as the moment to allow market forces a slightly more decisive role in the currency may do little to quiet mutters that markets will be welcome in China so long as they are pliant guests (see mess over equity market interventions for further evidence). However, some motivation for the timing can certainly be found in the IMF’s recent comments about the desirability of currencies eligible for inclusion in their Special Drawing Rights (SDR) basket being freely traded.
None of this is to say that we have no concerns with regards to China. This year’s weakness in auto sales is worth keeping an eye on given the consumer’s important role in helping to keep the show on the road while the older parts of the economy are slowly retired or reformed. Forty-one straight months of year on year producer price declines go some way to illustrating the scale of overcapacity that the economy is labouring to chew through. There is too much debt, and much of it is held in the wrong hands, while the reform agenda would be intimidating for a country a tiny proportion of the size and influence of China to name a few. However, for the moment, we continue to see Chinese authorities having sufficient will and means to avert a more chaotic slowdown. We still suspect that policymakers will be helped in the second half of the year by a pick up in global growth, with the US private sector at the heart of this acceleration. This week’s solid US retail sales, with decent revisions to the last few months data provides further ballast to this idea. A broadening economic recovery in Europe will also likely be helpful.
Implications for US monetary policy
The scale of the yuan decline seen so far looks significant relative to its own history, but is so far likely insufficient to move the dial for either China or the wider world economy. We will be watching carefully for further declines as there can be no doubt that a more pronounced decline of say 10 – 15% would likely have more significant implications for the path of inflation around the rest of the world and therefore monetary policy.
For the moment though, we still see US central bankers starting on the long road to interest rate normalisation later this year, likely at the mid-September meeting. Admittedly, wages in the US are yet to turn up more forcefully, a key strut of our expectation that interest rates will likely have to rise a little faster than the consensus currently expects over the next couple of years. However, a range of evidence points to labour supply starting to run thin, which would suggest that we won’t be waiting long.
Get invested and diversify remains our best advice. Emerging markets assets are a key part of this diversification. We retain a preference for Asian emerging markets over those elsewhere. Part of this is that we see the Chinese economy surviving, much like Colonel Kurtz’s snail, whilst managing to settle at a more sustainable growth rate.
1 The real effective exchange rate measures the weighted average of a country’s currency relative to an index or basket of other currencies adjusted for the effects of inflation.
William Hobbs, Head of Investment Strategy, Europe