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China Crisis? Yes, but no worse than two weeks ago.

The relationship between asset prices and fundamentals is complex. Evidence and intuition suggest that sometimes prices move for no real reason.

But even those of us who pay lip service to behavioural finance often find ourselves looking for explanations when we see the type of moves we have seen over the last couple of trading sessions.

So it is with China today. The apparent cause of equity falls is the recent adjustment in the means by which the currency is managed, which has resulted in the Chinese New Yuan to devalue versus the US Dollar by around 3% (see figure one).

Slide1

It is worth putting this into context. In 2014 the Japanese Yen moved more than 2% in a week three times, and in November moved nearly 6% without causing such market turmoil.

Moreover, as figure one shows, the move represents only a partial reversal of very large moves we have seen over the last five years. The Yuan’s peg to the US Dollar has served to harm Chinese global competitiveness for some time, note the upward trend in the currency against a basket of its trading partners:

Slide2

It seems that the currency move itself is not enough to justify the ‘rout’ we have seen in equity markets and other Asian currencies and so other reasons are being put forward. The most common are interrelated:

  1. The currency has a lot further to go
  2. The Chinese Central Bank knows something we don’t about how bad Chinese growth dynamics are.
  3. The currency move itself could harm Chinese companies with debt denominated in foreign currencies
  4. The move will spark ‘currency wars’ and the currency move itself will cause aggregate global demand to slow down by ‘exporting deflation.’

How valid are these arguments?

What we already know

The first of these points seems reasonable. As figure two shows, for the currency move to make a material difference to domestic growth dynamics it will likely have to be larger. Moreover, if as the People’s Bank are saying, the move is part of a gradual opening up of the currency to market dynamics then there could well be further pressures on the currency.

On the second point, the fact that the Chinese economy is slowing is not new news. We wrote about it and the possible pressures that this could put on the Chinese currency here. Despite official growth indicators suggesting a relatively healthy year on year growth rate of 7%, most independent economists are sceptical of this. The chart on the right below shows the difference between official PMI figures and the most commonly used independent measure. Figures below 50 suggest a contraction, not growth.

Figure 3: Wishful thinking? Chinese growth figures

Inconsistencies like this and other data such as weakness in China’s major trading partners, namely Taiwan, Thailand and Korea, have meant that most have tended to treat official data with a pinch of salt at best.

The idea that the situation is worse than official numbers suggest should not be a surprise. It was not uncommon to hear the argument that devaluation was likely and so it seems odd that when it finally does happen people should become even more pessimistic.

In the same way, the issue of Chinese companies with foreign-currency debt is one that has been at the forefront of investors’ minds ever since it became a key factor behind the Asian crisis in the late 1990s. In February, the FT quoted a piece from the Bank of International Settlements which suggested that foreign currency debt represented less than 4% of the total.

More importantly, attempts to tackle broader systemic threats like shadow banking and general indebtedness show that the issue is also at the forefront of policy makers minds. Will they be able to solve the threats they face? Perhaps not, but again there is nothing to suggest that they are less likely to now than a week ago.

Currency wars

As for ‘currency wars’ there is clear evidence of weakening growth and downgrades to forecast in Asia as a whole:

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This seems likely to prompt a policy response. The prospects for devaluation (‘competitive’ or not) and even QE seem elevated. Policy easing is already underway. One view is that when one currency embarks on such moves, others will follow in short order. Central Banks often display an ‘after you’ mentality when it comes to more unconventional moves.

But what would these devaluations mean for the global economy?

‘Exporting deflation’

It is worth remembering that if it is possible to ‘export deflation’ then at the same time you must be ‘importing inflation’. The initial net effect on global aggregate demand is zero.

Most bearish commentary on global growth has rightly focused on the slowing growth of China as the main reason for concern. However, few put the strong US Dollar (to which the Yuan is pegged) as the cause.

It seems odd then that a weakened Yuan should also be taken as a cause to worry about growth at global level – as though China will continue slowing as it was before AND, by devaluing, it will cause competing markets or those who export China to slow as well.

Currency moves should have no impact of your view on aggregate global growth unless you believe that it reveals something that you did not know before about aggregate demand, or if the currency moves impact those with US-Dollar denominated debt. Instead, as with any relative price shift there should be winners and losers.

Knock-on effects may vary, if the winners have a higher propensity to spend rather than save, as you may expect from Asia relative to the West (due to demographics and lower relative incomes in Asia), then growth could be positively impacted. Similarly, despite the widespread fear of all ‘deflation’, it is possible to have deflation alongside economic growth. The price of computers has been deflating for years and yet the Nasdaq is close to all-time highs.

Similarly, the US consumer could initially buy Asian goods more cheaply after devaluation. This is far removed from the idea of deflation as always reflecting lower demand. The Asian devaluations of 1997/8 for example, proved to be a significant boost to consumer real incomes and spending.

However these interplays are complex and hard to predict, there are simply too many variables which change too often to be overconfident in forecasting fundamental developments. The real question is whether you are receiving enough compensation for these risks. Which brings me to my last point.

What about the recent equity decline? There’s no secret…

In the last couple of days, as moves in the currency have slowed, commentary has turned to the move in the Chinese equity market as the cause of the volatility around the world. It is worth remembering that the fall in the Chinese equity market seems largely to have been a result of it becoming too expensive. We had discussed the frothy nature of the onshore market in an earlier post.

The chart below shows that in June this market had become even more expensive than the S&P 500, which itself has been accused of being overpriced. It had also got to that level fairly rapidly.

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Such bubbles have a tendency to pop, and can occasionally have an impact on the real economy. However in this instance it is very difficult to infer much from the behaviour of the Chinese market which has behaved in a manner unconnected with fundamentals for some time.

What we have seen is a rapid and meaningful improvement in valuations for developed equity markets where we have clear evidence of fundamental improvement, such as the US, Japan and Germany (see figure six).

Slide6

 

This improvement in equity valuation comes in the wake of an event which has, at best, ambiguous implications for the fundamentals of these countries. It could well be that investor panic has created an opportunity here.


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.