- China’s economy is showing signs of slowing, as it has done toward the end of the year in every year since 2014.
- That, combined with a rate hike from the Federal Reserve, will bring volatility to markets.
- The question is whether or not the Chinese government will solve this problem the way it always has – by making credit easier and putting aside the business of reform.
- The way the rest of the world gets impacted by a China slowdown is through the currency, said China analyst Charlene Chu.
For now, Wall Street is wailing about a lack of volatility in global markets. Give it a few weeks, and that will all change. China is about to take us all for a wild ride. We’ve taken this ride at the end of every year since 2014, and all of the elements for a repeat are coming together. China’s economic data has been slowing for the last two months, and the Federal Reserve looks ready to raise interest rates in December, yet again. This combination tends to strengthen the dollar and make US assets more attractive. So, money starts to move out of China and the yuan starts to fall and the order that was in place for the last few months begins to unravel.
Each year this volatility upsets the balance in China’s delicate economy. Something gives. It could be the outflow of funds from China pushing the yuan down, or a growing spread between the value of the currency traded in China, compared with that traded overseas (yes, there’s always a difference), or convulsions in the Chinese stock market that turn screens in financial capitals around the world red.
This year, though, Chinese President Xi Jinping has consolidated power, becoming the most powerful leader in the country in decades. Now that his grip on the country has been secured, some say, he will go about the dirty business of deflating the debt bubble building in China’s financial system since 2009 – the bubble that exploded China’s banking system from $9 trillion to $35 trillion in less than a decade.
In this scenario, instead of instructing officials to do whatever they can to stop the bleeding, Xi may wait for the pain to subside on its own – sending the global economy to destinations unknown.
“China’s economy pushes toward year-end with further signs of ebbing growth momentum,” wrote Bloomberg economist Tom Orlik in a recent note to clients. “Industrial output, fixed asset investment, retail sales, and property construction all slowed in October. After a year in which policymakers have been able to begin addressing financial risks without sacrificing too much on growth, trade-offs are going to start getting sharper.”
The song remains the same
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Here in the US traders are almost certain that the Federal Reserve will raise rates during its December meeting.
And of course, we have to remember that the state of the Chinese economy hasn’t really changed, no matter what Xi says about the reform and restructuring going on in his capitalist economy “with Chinese characteristics.” Last month, Chinese central bank governor Zhou Xiaochuan told a gathering of Communist Party officials to be wary of a ‘Minsky Moment’ – a moment when asset prices collapse under the weight of debt and the pressure of a sliding currency.
“If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment,” Zhou was speaking on the sidelines of China’s 19th Communist Party Congress.
“We should focus on preventing a dramatic adjustment,” he said.
China, as you know, has a debt to GDP ratio approaching 300%, and household debt is increasing. As for China’s currency, in each of these cycles, we’ve seen its strength tested. At one point you have to wonder if there will be a time when it no longer has the stuff to pass that test. Or to put it another way, if there will be a time when the government will accept a lower grade.
When the levee breaks
Part of the pattern we’ve seen repeated annually is that the turmoil brings a ton of consternation to the World Economic Forum in Davos in February. Leaders start to speak out, silencing the China bulls who insist the government will handle this complicated unwinding without a single mistake.
“It’s serious,” billionaire investor George Soros said at a Bloomberg event in Davos last year. “And the Chinese left it too long to address the changeover in the growth model that they have to adopt from – investment and export-led to domestic-led. So a hard landing is practically unavoidable.”
That’s about as dark as it gets. A few months ago we spoke to noted China analyst Charlene Chu of Autonomous Research about this point in China’s annual economic cycle. She told us that growth would likely flatline in the first quarter of next year.
“The way the rest of the world gets impacted by a China slowdown is through the currency,” she said. If the yuan catches what the economy has, the whole world will get sick.
So, the government may choose to pull the credit lever and add more debt to the system. There are two things that could make that option more than distasteful to the government (if it is indeed genuinely committed to reform).
The first is the property market. It went red hot early last year, the last time the credit lever was pulled, and then started to cool along with the economy in recent months. If China eases, the property market will heat up again, threatening market stability.
The second issue is less likely but more dangerous.
“One of the most dangerous risks we would face if we were to see in China is inflation,” Chu said, “because that means the credit machine turns off or slows down and that means growth slows down faster than we thought.”
You see, the only thing that could bring more volatility to markets than the Chinese government not using its credit lever is it not being able to. In that case, the entire world runs out of options.