China continues to rattle international markets, forcing the Federal Reserve to refrain from increasing short-term interest rates. The Fed’s much publicized desire to move away from the “zero bound” has been, in the Fed’s words, “data dependent.” Unfortunately, the Fed has had a terrible record in forecasting economic growth, acting more as a cheerleader rather than a central bank with particular insight. The Fed is in danger of losing credibility and becoming a source of market uncertainty. So what is going on?
China’s spectacular growth was based on selling to the western developed economies. It built a powerful manufacturing sector based on exports. Its singular economic advantage was a vast supply of unemployed or underemployed labor. Following the economic model used by post war Japan, China’s initially unskilled work force produced an array of inexpensive goods which have with time increased in sophistication. The globalization of production meant that a significant amount of manufacturing moved from the West to China. As part of its export drive, China invested heavily in infrastructure, building factories, roads, airports, high speed rail, and whole new cities. China was so vested in this development plan that even after the western economies slowed in response to the credit crisis of 2007-2008, it continued to grow 10% year. While that magic number, now recently reduced to 7%, may have been artificial, it was high by any standards. But to continue to grow at elevated levels when the markets for it exports had slowed required enormous amounts of debt. Bloomberg reports that Chinese debt (total outstanding debt and household borrowing) rose from 125% of GDP in 2008 to over 200% today.
Even the Chinese General Administration of Customs has confirmed the drop in exports, reporting that in July they had fallen 8.3% from a year earlier. With the export path to growth no longer available, many had thought China could grow independently and would, in fact, lead global growth. However, the shift to a domestic consumption led economy will take years to realize. In the meantime, many think that the Chinese have lots of reserves and tools to sustain substantial growth. Doubts have surfaced as China devalued its currency to support a falling stock market. Although the Markit PMI (a private measure of the Purchasing Managers Index) has been below 50 for a number of months, the official China Federation of Logistics and Purchasing PMI has also recently dropped below 50, the dividing line between growth and decline.
Command economies do not self-correct as efficiently as others, but they do correct, and often brutally (remember Japan, the Soviet Union). Chinese stocks were in a bear market from 2007 until last year. The Shanghai stock index declined 67% during that period. The government reduced bank reserve requirements, bank lending rates, and allowed margin accounts for individual investors. Much like quantitative easing in the US, the measures did little to influence the Chinese economy. However, they did provide liquidity to the equity market. The Shanghai index went up 158% between April 28, 2014 and June 8, 2015, the peak. The Shenzhen increased even more. Perhaps the Chinese government hoped to convert debt into equity. The subsequent and sudden market drop went well into bear market territory. The reluctant response has been to inject more liquidity into the system. Interest rates were cut further as were bank reserve requirements. But the authorities haven’t stopped there. Initial public offerings have been halted, and SOEs (State Owned Enterprises) were ordered to buy stocks, likely increasing the debt burden.
China’s woes have international implications. Just as China has had to liquidate reserves (estimated at $350 billion) to defend its markets and money outflows, other countries are having liquidity issues. Industrial commodity exporters are suffering from a lack of liquidity due to the collapse in demand for their products. In the U.S., regulations have reduced the trading positions that banks used to carry on their balance sheets. The Financial Times reports that the sovereign wealth fund of Saudi Arabia has been selling equities. This global lack of liquidity has contributed to the spike in volatility we have seen in recent weeks.
The challenges facing China are well documented and are unlikely to cause a global recession. We follow global economies and do our best to understand them. “Black Swans” by definition do not come from well publicized events. It is important to recognize that China built its economy on exporting to the developed world. It is the slow economic recovery in Europe and the U.S. that has affected China, not the other way around. Perhaps the markets may be coming to the realization that our problems are home grown. Something under the surface, such as developments in the credit markets may hold the key to future volatility.
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