Yuan thing after another for China economy
We are in one big global mess. On Aug. 11, an unexpected 1.9 percent devaluation of the yuan fueled fears about the outlook of the Chinese economy, setting off falls in commodity prices and emerging market (EM) currencies and equities over an extended period.
Stock markets in Europe and the United States wobbled and then fell sharply, culminating in the 1,000 points intra-day drop in the Dow Jones Industrial Index on Black Monday (Aug. 24).
Copper, aluminium, zinc and lead prices hit five to six-year lows; oil futures fell below US$40 a barrel; and the ringgit dropped to its lowest level since the Asian crisis in 1998.
As I see it, no single factor can be held responsible, even though most market managers say China’s poor economic outlook provided the spark. But what’s driving the two major nations — and their complex relationship — form the basis towards a better understanding of what’s going on.
The United States, still the world’s largest economy, remains the global financial powerhouse that sets the global direction in interest rates and currencies. China — still the world’s fastest growing big economy, is in the midst of a difficult transition involving market reforms that’s not working according to theory.
The two largest global economies appear to be pulling in different directions. While growth in the U.S. economy has been blowing hot and cold, it is beginning to gather pace with unemployment now inching down to 5 percent.
At this time, China’s economy is beginning to show more signs of weakness and losing steam. Still, it is determined to maintain gross domestic product (GDP) growth in the region of 7 percent and has enough degrees of freedom in policy easing to reach this goal. But the task is daunting.
Nevertheless, this divergence between the two giants is causing uncertainty and much anxiety, even trouble — especially among the EMs which had benefited from expanding Chinese demand ( emanating from its investment boom) and from the flood of cheap credit and easy money from the United States in particular.
U. S. growth prospects remain positive. But it also means that the “lift-off” in interest rates is eminent — the first time in almost a decade. That means U.S. dollar can strengthen — already up more than 15 percent against its trading partners over the past two years.
This puts a squeeze on EMs: (i) from capital outflows to capture higher yielding U.S. assets; and (ii) from rising currency risks in servicing EM’s US$1.3 trillion of U.S. dollar debt raised since 2010. The largest borrowers being China, Brazil, Mexico and South Korea. But China is slowing down. Its greatest impact is on commodity producers, from Indonesia to South Africa. Also on Singapore to South Korea and Taiwan.
Even India is feeling the pain — especially from the dumping of cheap Chinese steel. Also, the United States and China going their separate ways have further complicated their already complex relationship. U.S. “presence” in the territorial dispute among China, Japan and ASEAN is unwelcome.
Until recently, the yuan had tracked U.S. dollar’s ascent despite China’s slowing economy — indeed, the yuan had appreciated by more than 10 percent against its trade weighted basket since 2014. Its recent reversal has prompted concerns that with its growth sputtering, prospects of a currency war looms large.
I think such fears are overblown. I see the recent move more as being designed to strengthen the market role in determining the yuan’s value. Subsequent events have kept the yuan value in line with those of its peers — and remains part of its reform exercise, not a shift in exchange rate policy.
Global stocks and commodity prices fell sharply early on Aug. 24 as the previous weekend’s meltdown intensified.
The Dow was in correction-mode on the previous Friday, falling 10 percent from its previous peak following its worst week since 2011 when U.S. sovereign debt rating was downgraded.
In stockmarket-speak, a “correction” refers to a 10-percent decline in the price of a widely followed index (such as the Dow or S&P500).
It slips to become a “bear” if the fall is 20 percent or more (just a rule of thumb). Black Monday’s Dow plunge was the biggest ever intraday point decline, following the 8.5 percent fall in the Shanghai Composite which pushed it into negative territory for 2015, having risen by as much as 60 percent to its June peak (after doubling over the preceding 12 months).
The pan-European Stoxx Europe 600 closed 5.3 percent lower, the biggest one-day fall since December 2008, losing all its gains in 2015. Stock markets across Asia — from Japan to Australia — slid more than 4 percent on Black Monday.
A large number of currencies in the region fell to multi-year lows. Japan’s Nikkei benchmark tumbled 4.6 percent, and Germany’s DAX, 4.7 percent — having now lost more than 20 percent since its April peak. Oil prices fell 4 percent while basic resources firms on the Stoxx 600 were down 9.3 percent.
The speed of the recent sell-off has left investors nervous and uncertain. The notorious “fear gauge, VIXX” (the CBOE Volatility Index) had more than doubled over the past week, the biggest weekly rise on record.
All these reflect intense weakness in commodities and EMs as well as concerns about China and overall global growth, and rising risk of yet another financial crisis. But sometimes, markets do get quirky; irrational behavior takes over and develops a logic of its own.
That’s in the nature of markets — they often tend to overshoot and undershoot. In the last six trading days until Aug. 25, the Dow had lost nearly 1,100 points, or 11 percent.
Markets Get Battered
As a result of being squeezed, policymakers in many EM nations are struggling to cope with several factors beyond their control that have, when combined and in conjunction with destabilizing “host” socialpolitical issues, hit their currencies hard.
Among them are growing doubts about the health of the Chinese economy, the sharp decline in oil, basic food and industrial metals prices, the likelihood of rising U.S. interest rates and in the case of Malaysia, irreducible uncertainty and constant anxiety over political stability issues.
As a result, global money managers have pulled-out an estimated US$26 billion in EM stocks and bonds during the first seven months of this year. There has been practically a total carnage of commoditybased currencies.
The mood is grim from the South Africa rand to Kazakhstan’s tenge; from Vietnam’s dong to the rupiah to the ringgit. The tenge has since fallen by more than 25 percent against U.S. dollar; the Brazilian real by 35 percent (currently at a 12-year low) and South African rand by 13 percent, while Vietnam’s dong formally devalued again for the third time. By now, the rupiah is down by 12.5 percent and the ringgit, by 18 percent to a 17-year low and by 29 percent over the past 20 months.
Malaysia’s economic- socialpolitical underpinnings have eroded significantly since end-2013 and investor confidence has been badly shaken. Given poor sentiment, capital outflows (both short and long) have been significant. Still foreigners continue to hold about 45 percent of the government’s debt, while private foreign currency denominated borrowing (mainly in U.S. dollar) today accounts for about 24 percent of GDP.
Malaysia urgently needs to fix (and reform) its investment ecosystem. Above all, it badly needs dependable statesman-like political leadership to revive confidence. At the end of the day, the combination of a weakening currency and the absence of firm, predictable political stability is affecting everybody, including meeting the ultimate aim of public policy to raise living standards.
For most EM currencies, they need to adjust to the rebalancing taking place in the global economy, in particular to the often divergent policy stance of the United States, Europe and China. The rupiah, ringgit, baht, dong, lire, rand and real continue to remain vulnerable.
What Then, Are We to Do?
Unlike previously, China is today intricately connected to the world community. Its global footprint is fast expanding. It is no coincidence that the recent market crash is correlated with both tepid underlying world growth and with the vast capital outflows from EMs. These three trends are mutually reinforcing. So the world has changed. Still, higher U.S. interest rates (when it comes) need not spell doom. If the “lift” is gradual (as expected), EMs may not feel it all that much.
The presumption that the U.S. dollar will further strengthen as a result has not been proven empirically. In the first 100 days of the four big U.S. tightening cycles over the past 30 years, U.S. dollar actually weakened every time. So, higher rates will add to the allure of U.S. dollar assets but may not actually drain-off too much more capital from EMs. But there are just too many moving parts. Until the market correction settles down, EM currencies stabilize, and the real economy shows clear signs of health, the stench of crisis will remain.
What’s the investor to do? I suggest four things:
— Stay cool: U.S. stocks are not really cheap even after Black Monday, trading at 24.9 times average long-term earnings according to Nobel Laureate Yale professor Shiller (down from 27 times in early 2015).
— Ignore blow- by- blow news: Constant updating about the markets only unsettles and blurs your perspective. Focus on your long-term goal.
— Ignore utterances of “correction” or “bears” and “bulls”: They have no real significance. What matters is the future outlook.
— What’s going to happen?: Market pundit talk is just that — talk. No one really knows what the market will do next. Trust your gut-feel and self-knowledge against irreducible uncertainty.
If you have not suffered any loss, you shouldn’t be in stocks — and shouldn’t feel deprived either! Good luck.