October 7th, 2015

After Fed delay, investors consider Chinese elephant in the room

by Enrico Colombatto Financial markets did not react well to the […]

Team AEC

Financial markets did not react well to the Federal Reserve’s decision in September to keep interest rates stable. Presumably, investors were worried that China’s slowdown is more serious than anticipated, and that the Fed has well-founded concerns about the outlook for the American and European economies.

While the Chinese economy’s gradual deceleration is indeed problematic, its consequences pale in comparison with what could happen if frustration and disappointment led to a systemic crisis in that country. The advent of a new populist or military leadership in Beijing could be the signal for a worldwide market crash. The possibility of a Chinese political shock will loom ever larger as a determinant of investor behaviour and market volatility, alongside uncertainty about developments in the United States, the eurozone, Africa and Russia. This situation will present Western monetary authorities with new challenges.

The United States Federal Reserve Board backed off earlier signals and chose once again to postpone its first interest-rate increase since 2006. Those who want to see the end of an artificially loose monetary policy will have to wait a few more months. The decision was not a big surprise. Many observers had noticed that US policymakers were deeply impressed by the sharp fall in Chinese stocks in response to slowing economic growth – a slowdown that could be sharper than official statistics would have us believe, with potentially severe repercussions throughout the world economy.

Fragility focus

In investors’ minds, the bad news (monetary authorities are hesitant) prevailed over the good news (money will stay cheap for a few more weeks or months). Rather than celebrating, investors started speculating about the weak spots in the American economy. Their conclusion was that the Fed’s strategy may have more to do with the fragility of US growth than with China. Some commentators have drawn attention to the energy sector, where many American producers are in serious trouble due to low prices and relatively weak demand. Two additional reasons for concern are weak private investment, a phenomenon that might slow down future growth, and near-zero inflation, which investors usually perceive as a signal of sluggish demand.

The outcome has been more uncertainty, both about the world economy and about how the policymakers will react to future events. In financial and currency markets, such concerns translate into greater volatility. Regrettably, there is a long list of areas where fears about the future have clustered. Besides China and the US, there is Africa, where growth is slowing and public debts are piling up; Brazil, whose economy is contracting and inflation is running at almost 10 per cent; Russia, also in recession with 15 per cent inflation; and even the eurozone, where economic performance continues to disappoint.

China concern

In this catalogue of trouble spots, the most worrying at this moment is China. Most economic observers are aware of the problems the Chinese economy is facing – massive bubbles created by an overly expansionary monetary policy, inefficiencies bred by corruption and the shadowy interactions of big business and powerful political groups, and the central authorities’ own clumsy policy decisions. At first glance, the macroeconomic data published by Beijing is reassuring, but most analysts are convinced the official statistics are unreliable. Regrettably, we have no idea by how much the data is in error.

The problem posed by China is unique in another respect. While the broad direction of economic developments in Russia, Africa and parts of Latin America is predictable, with the uncertainty involving matters of degree, the future evolution of China could be a matter of tipping points that lead to widely divergent outcomes. These two sets of phenomena – degrees and tipping points – are the keys to understanding what could happen on financial markets over the next few months, and why volatility is already increasing.

Known knowns

The general economic situation in most of the world is well-known and unlikely to change much in the near future. The rich countries are growing at a slow pace with near-zero inflation. These countries have not overcome all the structural problems that led to the global financial crisis eight years ago. The condition of public finances and sluggish investment by the private sector are still delicate issues for both the eurozone and in the US. Yet most economists agree that moderate expansion is going to be the most probable scenario, and that the fiscal and monetary authorities will do whatever it takes to ensure a minimal acceptable level of real GDP growth – at least 2 per cent in the US, and 1.5 per cent in the eurozone.

There is a consensus that the fate of the Russian economy will be determined by the price of oil. Thus, Russia’s performance will deteriorate as long as crude stays below US$60 per barrel, with consequences that might become more acute should the West intensify sanctions imposed after the seizure of Crimea.

Accepting risk

In a similar vein, more and more analysts now agree that Africa will struggle to sustain the fast growth rates of recent years, regardless of individual successes in some countries. Institutional reforms and efforts to stamp out corruption are going to take time; decrees will not suffice. Markets are aware that some African countries may default on their rapidly increasing public debt, and investors have already reacted by reducing their exposure to Africa. But if the continent’s boom days are over for the time being, nobody is expecting a crash. Rather, investors have become used to the idea that poorly run economies, plagued by corruption and led by unstable political elites, are at best an opportunity for quick gains if one can stomach the risk.

From this standpoint, we can conclude that one kind of volatility derives from uncertainty over the price of oil and the strength of the Western economies – which some economists believe have emerged from the latest crisis but are not too far from the next one.

China tips

China, as mentioned earlier, is radically different. Here it will be tipping points, rather than deviations from known trends, that will shape the future in financial markets and beyond. Recent developments in China have not yet disclosed any new phenomena. The country is beleaguered by a host of problems, most of them linked with the necessity of changing its economic and political model to accommodate slowing growth, an ageing population, rising aspirations for consumption and the escalating costs of uncontrolled development and pollution.

While some Chinese industries will come under heavy pressure during the coming months, the economy as a whole is not about to collapse. Instead, the big news has been the authorities’ continuing inability to come to grips with the country’s problems and defuse tensions. The most recent example was the official campaign to buy stocks over the past few months, a suggestion followed by millions of ordinary people (including military personnel), who then lost their savings, provoking deep and widespread resentment across the country.

At some point, Chinese society will no longer tolerate such deficiencies in its rulers. At that (tipping) point, the political system could break down: people would take to the streets and – regardless of whether the mass protests prove successful or are suppressed – a different political elite will emerge. Perhaps these new leaders will rise from the rank and file of the party, or perhaps from the army or security forces. In a crisis situation, they will not be inclined to trust market forces. More likely, financial markets would be shut down for many days or weeks, price controls would be introduced, and the new elite would seek legitimacy in belligerent nationalism.

Awkward position

That sort of tipping point would be sufficient to produce a worldwide crash in financial markets and a considerable rally in the price of gold. One by-product of a Chinese crash would be to put Western monetary authorities in an awkward position. Monetary fine-tuning will become very difficult without China as a willing buyer of Treasury bills and bonds. Much as Western central banks would like to inject liquidity and soften the crash, many will have to settle for the higher interest rates needed to find new customers for government debt.

This dramatic scenario may not be imminent, but is now starting to pop up on investors’ radars. Its potential consequences are so dreadful that even a small increase in its perceived probability would shake the confidence of experienced traders and analysts, producing a psychological tipping point. Whoever fails to take the hint from this increased market volatility will be taken by surprise yet again.

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