It may seem odd that the sudden devaluations of the Chinese Renminbi have caused such a stir in financial markets across the globe but it does make sense when you stand back and look a the bigger (troubling) picture. More to the point it rather compromises the complacent views of Central Bankers and politicians that we in the West are on track with a steady sustainable recovery that will see interest rates normalize over the next few years. Once this myth is dispelled a whole load of other assumptions evaporate (the Euro anyone?).
While the issues surrounding this are complex and will undoubtedly result in myriad books written with hindsight, largely by those who had little foresight, let’s look at a few key points now.
As recently as last week we pointed out the weakness emerging (ahem) out of emerging markets (here), which was particularly troubling after it became undeniable that global trade, which had been dominated by Emerging Markets in recent years, was also slowing dramatically (here). This has consequences, particularly in a world where the Japanese have gone gang-busters on QE to depreciate the Yen, which has forced the Korean’s to delay their promised rate hike as the Won rose in relative value, making Korean built Hyundai’s more expensive than Japanese built Honda’s. Closer to home one of the few rational reasons for Germany’s determined effort to destroy any sense of European unity and co-operation is that it’s “I’m all right Jackboot” attitude of leaving Southern Europe in crisis results in a perpetually weak Euro, which is great for their export machine (it is unlikely this is the core driver…stupidity and ignorant arrogance almost certainly lie at the core of the policy).
In this environment of almost unnoticed global currency war the Chinese in particular have lost out as not only has he Renminbi been loosely pegged to the appreciating dollar, against which it has strengthened anyway, but in terms of the currency’s Real Exchange Rate (RER) and a Real Effective Exchange Rate (REER), which factor in elements such domestic inflation, the relative price of goods and services, trade volumes and so on, it has appreciated dramatically, leaving it looking very over valued.
This is troubling, for in the words of IMF economist Luis Cato “Imperfect though they may be, REER’s have signaled large exchange rate overvaluations in the run-up to many financial crises”.
The truth is that the inflation suffered/enjoyed (remember we want more of it apparently!) over recent years in China has made them less and less competitive as they have tried to bring record numbers of people into a modern economy at an unbelievable speed. As a result Chinese goods and factories are no longer as competitive as they were, with Western companies increasingly looking to produce in lower cost countries such as Vietnam, Myanmar, Bangladesh, Mexico, or even re-shoring to peripheral Europe and North Africa, particularly in lower value added products.
Not only does this impact China’s export driven growth model it is occuring before it can build compensatory internal demand from a growing middle class whose prosperity is in large part built upon the export boom, while stimulatory factors designed to offset the larger global slowdown, specifically the property and then stock bubbles, look set to be a significant drag, at best, over coming months and years.
But why does this hurt other markets so?
Well apart from the impact China had on the headline global growth figures following the GFC and the knock-on positive trade implications with its neighbours, it has also been key to helping Germany pull itself out of the global downturn as it supplied not only high end engineering to the growing Chinese manufacturing, infrastructure and building sectors, it also produces the most popular high-end, high-volume automobiles. However recent results from BMW, Audi, Mercedes (and Jaguar Land Rover in the UK) point to a steep slowdown in Chinese sales. This in turn perhaps explains why the German DAX has been the hit particularly hard in this pullback.
However the biggest issue really is the deflationary pressures that this depreciation unleashes. Despite Central Bank hand-wringing over raising interest rates the truth is that inflation has not been an issue for sometime, which is a worry when it is seen as a way to erode our massive debt loads.
Late last year we wrote that the concept of the UK and US entering an era of rising interest rates was misplaced and that ultimately the idea that US rates would rise more than 0.5% was far less likely than QE4 occurring. With this news we think this is more likely. There is simply no need to raise rates, although 0.25% may happen just for form, while the US will get increasingly uncomfortable with an ever appreciating dollar and the growth slowdown that will accompany it. This is likely to trigger the only fresh stimulative actions the Fed can currently think of…….more QE.
Let’s leave the (almost) last word to two well know characters who have strong views on this topic. The first is Hedge Fund behemoth Crispsin Odey, who in a note penned on the 31st July, stated:
“From where I look, China seems to be sacrificing any growth it might get out of its misshapen economy by holding onto the currency peg with the US dollar. The day that China understands that it must devalue, is the day that deflation really breaks out across the world. It doesn’t feel that good even now.”
And now for out favourite bearer of gloomy tidings, from Soc Gen, Albert Edwards, in a note out today, 12th August:
….Make no mistake, this is the start of something big, something ugly……