Financial Markets Miss A Bigger China Devaluation

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By John Richardson

FINANCIAL markets are like children in that they are incapable of focusing on more than two things at once, according to according to Stephanie Flanders – JP Morgan Asset Management’s chief market strategist for Europe.

To justify her claim, she makes the very good argument in an FT article that this time last year, global stock markets were in major panic over China’s decision to devalue the yuan against the US dollar. This occurred as China’s stock market bubble went pop, and as there was belated widespread recognition that China’s economic reforms were going to be a long, difficult and very uncertain process.

Wind the clock forward 12 months and the financial world seems as if it has almost entirely forgotten about China.

It is instead heavily focused on the strength of the US economy as being capable of doing the heavy lifting, almost by itself, necessary for a sustained global economic recovery.

Equities have also been cheered by the notion that the impact of Brexit will be confined almost entirely to the British economy, and that, anyway, if there is  wider  collateral damage, the world’s central banks will step in with lots more monetary stimulus.

But Flanders makes the point that on a trade-weighted basis against a basket of competing currencies, the yuan (RMB) has fallen in value by 6% so far this year. Last year, the yuan weakened by the less than this amount, and its depreciation was only against the US dollar.

The yuan’s devaluation in 2016 is detailed in the above two charts. The right-hand chart shows the CFETS (China Foreign Exchange Trade System) RMB index, which measures the value of China’s currency against this broader basket of other currencies.

This devaluation has occurred as evidence mounts that China is exporting more and more deflation in order to compensate for weaker economic growth at home, with these greater exports obviously supported by the  weaker currency. We are seeing this in gasoline and diesel markets. And in polymers, China’s polypropylene (PP) imports increased by 51% in January-June 2016 to 151,000 tonnes.

“Not to worry, China is determined to ease the pain of restructuring through lots more bank lending, and so this will keep its economy very strong. We saw this quite clearly during the first half of this year, when credit issuance once again went through the roof,” is the counter argument to this theory.

But I don’t hold to this argument for two reasons:

  1. Much of the new bank lending has gone to keep companies that are struggling with overcapacity afloat. Private investment, which accounts for 60% of the economy, is now growing at 0%, according to HSBC. New credit is flowing mainly to the state-owned enterprises that confront the biggest overcapacity challenges.
  2. Xi Jinping and his fellow reformers have gained greater control over economic policy and, more crucially, how policy is being implemented. Centralisation of power under Xi lays the groundwork for an acceleration in the pace of economic reforms, which guarantees a lot more pain ahead. I shall cover this theme in more detail in later posts.

It is also quite clear, if you look at the data in the right way, that there is no real underlying strength to the US economic recovery. The US is entirely incapable of doing the heavy lifting for the rest of the global economy.

As for Brexit nobody knows what happens next, least of all perhaps the British politicians and civil servants charged with achieving what seems virtually impossible.

The well-documented core of the problem is how Britain will continue to gain access to 500m-strong single EU market without accepting the same, existing rules on the free movement of labour, in its post-EU membership deal. It was objections to these rules that led to the success of the Brexit campaigners.

Britain’s politicians face an incredibly difficult choice. If they put a deal to the British people whereby the country agrees to the same free movement of labour rules in order to maintain access to the single market, major political and social unrest seems highly unlikely.

The question would then become: If this is the shape of a post-EU membership deal, why bother leaving the EU at all?

Alternatively, politicians may choose to refuse to accept EU conditions on free movement of labour. But then access to the single market seems almost certain to disappear, given the political and economic mood in mainland Europe.

Building new bi-lateral and multi-lateral trade deals that fully replace access to the EU single market might well take many, many years – assuming, that is, that new trade deals on this scale can be established. In the interim, the damage to Britain’s economy would surely be substantial.

The Brexit vote also represents something wider and even more worrying: The rise of populist politics in the West in general.

If populist politicians first in the US and then in France also win respective upcoming presidential elections, how might this effect global free trade? There is a risk that we are dragged into a global trade war, reminiscent of that which made the 1930s Great Depression a great deal worse than would have otherwise been the case.

But let’s not blame financial investors here for their role in distracting attention away from the complexities of all these issues. The job of a short term investor is to overlook complexity so that she or he can make binary, and very rapid, buy or sell decisions. That’s what they get paid to do. That’s their job.

Chemicals companies, though, are very obviously very different. They have to embrace and respond to today’s ever-growing complexities and uncertainties, which are entirely the result of the end of the Economic Supercycle.