Exit bull, chased by Chinese bear
THE Winter's Tale contains Shakespeare's most famous stage direction: Exit, pursued by a bear . Is that what is about to happen to the bull market, after last week's blood-letting? And is this particular bear Chinese? The biggest recent shock to the markets has been the Chinese currency devaluation. It was rather small, as devaluations go, and the yuan is down a mere 2.8% from its pre-devaluation levels. After the initial wobble, the yuan has held steady. The Chinese authorities are spinning it as a one-off event and say they have no intention of letting the currency slide. Nevertheless, it was a nasty surprise to the markets and added to the fears that something is rotten in the state of China.
The market has always had a touching faith in the abilities of the Chinese Communist Party. Not without reason-it did turn the country into an industrial powerhouse within a couple of decades. Its rise has been a great boon to a raft of commodity exporters. The strength of the Chinese market has been a life-saver for many businesses. And the party's ability to deliver results has led to the belief that it will be able to manage China's difficult transition from an export-driven and investment-led economy to one more reliant on household consumption without a hard landing.
But the devaluation and the earlier crash in the Chinese stock market have shaken that faith. In spite of throwing billions of dollars at the market, in spite of curbs on selling, the Shanghai Composite index is now a whisker above its closing price on 8 July, immediately after the crash. Political problems are mounting. President Xi Jinping's crackdown on corruption and reforms have come up against "unimaginably" fierce resistance by entrenched interests, according to Chinese state media quoted in the South China Morning Post. The crisis of confidence has led to massive capital outflows from China. Everyone knows the course of true reform never did run smooth, but the nagging suspicion that has now reared its head is: Has Xi lost the plot?
The catalyst for Friday's carnage in the markets was China's flash manufacturing Purchasing Mangers' Index (PMI) for August, which came in at a 77-month low. This is the sixth successive month the index came in below 50, which means the manufacturing sector is contracting. What's worse is that the pace of contraction speeded up in August. Four interest rate cuts since last November and lower reserve requirements for banks do not seem to have had any impact. Chinese growth is important simply because in these "new mediocre" times since the financial crisis, China has contributed about one-third of the growth in world gross domestic product. With growth hard to come by these days, China was a beacon of hope for the world economy. Many countries, ranging all the way from Australia to South-East Asia to Brazil, will see slower growth now that China is decelerating. Small wonder global markets are crying plaintively, "Et tu, Xi?"
Increasingly, the worry is that nations will turn to currency wars to prop up growth. The Chinese devaluation, modest so far, has already led to a wave of currency depreciation among emerging markets. If we look at the flash PMIs, we'll see that growth has accelerated in the euro zone and in Japan, the two regions that have been able to weaken their currencies substantially. In the past year, the euro is down nearly 14% against the dollar, notwithstanding its recent sharp move up. The Japanese yen has depreciated by nearly 15% in the past year. On the other hand, the US is being hurt by the strong dollar, as seen from the August flash US manufacturing PMI, which has dropped to the lowest level since October 2013. So far, all we've had are currency scuffles, but it will take little to cry havoc and let slip the dogs of currency war.
Will the crack in the markets deepen? The US Fed is unlikely to take kindly to any major disruption in the market. After all, increasing asset prices in order to stoke the wealth effect has been an explicit objective of the Fed. Recall that the downturn in US markets last October dissipated as soon as Japan announced another dose of quantitative easing. Any serious cracks will see central banks leap once more unto the breach with pots of money, never mind that it will inflate the global liquidity bubble, already enormous. But any rebound will not alter the fact that the old global growth model, with US debt-fuelled consumption and Chinese debtfuelled investment as its twin drivers, is broken and no amount of throwing around central bank money is going to mend it.