After hard selling into Friday’s close in the U.S. and a global selloff in stocks today, it is clear that the Chinese mini-devaluation has begun a crisis, despite the Yuan appreciating for a seventh day. The mini-devaluation is merely a catalyst for a long overdue correction, But three questions remain. First, will the capital flows out of China force China to let the Yuan slip again? Second, will the downdraft in emerging market and commodity-heavy economies like Canada infect Europe and the United States? And, third will the US Federal Reserve resist rate hikes in the wake of the turmoil? My thoughts on those issues are below.
In terms of the market selloff, I mentioned on Friday’s Boom Bust show that the massive selling into the close Friday was a bad sign because it meant traders had three days to contemplate next moves. Without any positive news flow, heavy selling into a Friday close sets up heavy selling on Monday. This is how Black Monday panned out in 1987. And sure enough, this is how this people are describing Monday’s 8.5% sell-off in China, as Black Monday. All markets are down across Asia and Europe as I write this. And Dow futures are down over 400 points. WTI Crude fell to $39 a barrel. The 10-year is trading below 2% as it catches a safe haven bid. And EM bonds are getting creamed. It is a crisis.
And let’s remember that it is panic time despite the Chinese having set their peg higher for the seventh consecutive day. None of that matters now after the mini-devaluation because mindsets are different. I like what Edward Chancellor has to say about the cost of China’s devaluation. Here’s a quote at length from his recent Reuters piece:
The era of ultra-low U.S. dollar interest rates has lured global carry traders to China. It’s easy to see why. Chinese banks paid better deposit rates than their U.S. counterparts and yields were even higher in the country’s shadow banking system. In addition, carry traders could expect to earn a few percentage points from currency appreciation each year. To many foreigners, lending in China with an expected annual return of around 10 percent must have seemed a one-way bet.
The inclination of Chinese borrowers to avail themselves of foreign loans has been driven by need as much as greed. Of course, it has been cheaper to borrow abroad and the rising yuan shrunk the size of outstanding liabilities. More to the point, as the country’s credit boom continued, China’s financial system has strained to keep up with demand. Foreign lenders have filled the gap.
Furthermore, as China’s non-financial debt has climbed above 250 percent of GDP, the costs of servicing these obligations has become extremely burdensome. Two years ago, Fitch estimated that Chinese corporate interest payments were 11 percent of GDP and rising rapidly. Foreign loans reduced this burden.
The result has been a surge in Chinese overseas borrowing, much of it from foreign banks. The Bank for International Settlements records that global banks’ net U.S. dollar lending to China rose from around $100 billion in late 2012 to nearly $650 billion by mid-2014. The BIS also notes that Chinese corporations have increasingly taken to borrowing abroad through their overseas affiliates – a type of borrowing misleadingly recorded in the national accounts as foreign direct investment.
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In recent months, China has experienced large capital outflows, estimated by Goldman Sachs to have reached some $224 billion in the second quarter. As the global carry trade retreats, foreign bank lending to China has collapsed – it’s down by around $250 billion over the last year, according to the BIS. While Beijing was maintaining its currency peg, these outflows forced the PBOC to sell foreign exchange reserves and buy renminbi.
The trouble is that when a central bank swaps foreign exchange for its own currency domestic liquidity tightens, something that China’s cash-strapped corporates can ill afford. The PBOC has reduced the reserve ratio requirement – the money that banks must hold at the central bank – to 18.5 percent of deposits and could lower it further. But it’s not clear whether this would be sufficient to offset tightening liquidity conditions. Historically, there has been a strong correlation between growth in capital inflows and growth in Chinese bank deposits.
The alternative was to let the currency depreciate, thus upsetting the calculations of all those who were relying on the renminbi’s continued appreciation, or at least stability, relative to the U.S. dollar. Chinese foreign borrowers – particularly real estate companies, many of which have large dollar debts – now face the consequences of having mismatched their assets and liabilities. Thai finance companies found themselves in a similar predicament in 1996.
Looking to China specifically here, the Chinese controlled devaluation policy is going pear-shaped rather quickly. The capital outflows have clearly surged. Thus to the degree the Chinese do not allow the exchange rate to depreciate, they are tightening domestic credit conditions, making a slowdown and hard landing inevitable. Anyone who goes through the likely decision tree outcomes would say a reduction in the reserve ratio requirement, an injection of central bank liquidity AND another depreciation of the Chinese currency are coming. The first two are par for the course, but the impossible trinity of liberalized capital flows, fixed peg and independent monetary policy makes the currency regime untenable. A controlled devaluation will have to gather pace, with a 10% down move a likely scenario. Russell Napier is talking about 20%.
What happens to equity markets when the Chinese devalue 10%? What happens to emerging market currencies? And what happens to global trade and economic growth? Here’s the thing: irrespective of whether equity markets find their footing again, the Chinese currency regime is now unstable. The outflows from the Chinese carry trade will continue and that means currency depreciation, which also means that China will export deflation in a big way. Further turmoil is inevitable. So that answers question number one about further devaluation and its consequences.
Then comes the question about whether the downdraft in EM will infect US and European share markets and economies. Well, we are seeing the contagion to shares already. The S&P will almost certainly join the NASDAQ, Dow Jones, and the major European bourses in correction territory later today. But right now, the real economy looks pretty good. In terms of infection, I would expect Germany to be particularly vulnerable here given its large trade ties to China. If the Chinese currency depreciation and real economy slowing are substantial, then we should expect to see weakness in trade figures out of Germany.
For the US, it isn’t clear that what happens has real economy consequences yet. China is a net exporter to the US. So economic weakness can impact the US economy through trade flows, but trade is a much lower percentage of US GDP than it is in Germany. Where we could expect to see contagion is via the vulnerable risk-on segments of the US economy. Subprime auto, student loans, energy high yield and leveraged loans. These are all areas I warned in late 2014 are vulnerabilities for 2015. To the degree that the real economy in the US is infected, we should also expect to see problems with municipal finance as well.
From an upside perspective, government bonds are still the call here, with the convergence to zero trade I highlighted in January now back on in full. The outliers that I mentioned were Australia and New Zealand. And with the selloff in commodity prices gathering steam, we should expect those bond yields to converge downward. In an intensifying deflationary environment, convergence to zero becomes the status quo.
On the last question of the Federal Reserve, the concern has to be about divergent monetary policy. But the market signals from Yen and Euro strength are that the chances of the Fed raising rates have lessened. After today’s episode, they will have lessened even more. Larry Summers was using the FT as a bully pulpit over the weekend to implore the Fed to stay the course. And given that he was the individual contending for Yellen’s job, his entreaties have weight. What the Fed is concerned about here is that they hike rates and it is a catalyst for US-based risk-off portfolio shifts that infect the real economy. They do not want to be blamed for the next recession. And so the Fed is loath to hike rates during times of market volatility. This is not to say they won’t do it. But the bar is now much higher.
In any event, this is a crisis. The question now is about how widespread it becomes.