Dragon must escape from its own debt trap

THE sharp drop in the major equity markets last week, inevitably dubbed ‘ Black Monday’, thankfully didn’t last too long and proved to not be too calamitous.

In the history of stockmarket crashes, the oneday slide is somewhere down near the bottom of the league table and is nowhere near the scale of the 1987 crash.

Come ‘Turn-round Tuesday’ the markets were regaining their poise, and by the end of the week, while it would be generous to say it was ‘Happy Friday’, the markets seemed to be on a better footing.

Reports that the Chinese authorities had been heavily intervening seemed to bolster investor sentiment. Not that we are in a position to criticise. After all, the US Federal Reserve’s ultra- easy monetary policies over the past 20 years or so have pumped the S&P 500 index to record levels and taken leverage back to 2007-crisis levels.

In the US, official shortterm interest rates have been close to zero for 80 months in combination with a succession of moneyprinting, or quantitative easing, programmes which has exploded the Fed’s balance sheet to $4.5 trillion.

Why we still need emergency monetary policies when the US economy is not in an emergency or in a depression is a very debatable question.

International investors are now worried that the Fed, by delaying a ‘normalisation’ of policy, is left with very little monetary ammunition to combat the next recession and the next financial crisis.

The same story applies to the Bank of England.

Which brings us to China and the decision to devalue its currency on August 11.

While the devaluation was a modest 3pc, compared to the 33pc devaluation in 1994, it did mark an important reversal in the previous trend of Chinese currency appreciation.

China essentially runs a so- called crawling peg against the US dollar. This ties it into the Fed’s monetary policy, but the peg will eventually break.

It also means that to pre- vent the currency from appreciating too far, China would have to buy US dollars. This previously pumped up China’s foreign exchange reserves to the largest in the world at nearly $4 trillion.

China used the money to buy up American IOUs and is now the biggest official holder of US Treasury debt. It basically funded the US budget deficit, which peaked at 10pc of GDP in 2009, and also by buying US debt helped prevent a dollar crash.

China’s astonishing boom turned it into the world’s second-biggest economy, accounting for 16pc of global GDP, and also into the world’s biggest commodity importer. Most of the US trade deficit is accounted for by its shortfall with China. The credit boom has also meant that Chinese banks are now the biggest in the world.

An unfortunate side effect is that China’s debt has exploded by $ 27 trillion since 2007 and it has one of the biggest debt-GDP ratios in the world at 280pc.

Our experience in the West is that debt-fuelled bubbles always burst, and typically end in a prolonged economic recession.

There are signs that the global financial bubble, courtesy of an explosion in central bank balance sheets, may be dissipating.

CHINA is slowing down as it looks to move away from a growth model based on over-investment which has produced excess capacity, and is also reducing its foreign exchange reserves in the face of substantial capital outflows.

The commodity super-cycle is over – oil and commodity prices have collapsed to multi-year lows, which is good for western consumers.

But a wave of ‘ Made in China’ deflation can also smash emerging market economies, crimp profit margins in the West and raise the risk of global recession.

Bear in mind that China accounted for 40pc of global economic growth last year. Now it looks as though the Chinese Dragon is breathing less fire.

Let’s hope he doesn’t expire completely.