By Brian Perez
The Chinese miracle is slowing down. Accompanied by U.S. monetary policy pressures, a potential conflict in global-domestic macroeconomic goals, and a domestic policy-making behaviour focusing on opaque, unpredictable command-and-control measures, markets have developed heightened sensitivity towards the country’s internal and reporting policies. In turn, large spikes have occurred in the volatility of various global market indices — noticeably turning major indices toward the downside. Though the above are far from the only possible causes of the recent spike in equity price volatility, they do provide a succinct description of some of the important dynamics behind it.
The Chinese “miracle” — goals, slowdown, and contemporary issues
The world economy is an extremely complex environment. Each economy affects the general performance, sentiment, and outlook of the global marketplace, though arguably none more so, in recent periods, than the Chinese and American economies. The Chinese miracle was a darling of businesses, households, and investors alike, largely due to its extraordinary three-digit percentage gains in the various Chinese stock markets over the course of just a few years, and the accessibility it offered to the Chinese masses.
Of course, as with any development story, extraordinarily rosy growth is never meant to stay. The country will eventually have to slow down, and an increasingly bubbly real estate industry, debt levels of worrisome heights, lagging consumption, and dismal net export results serve as manifestations and confirmations of this expected slowdown.
Before delving into more aspects of the situation, though, we have to contextualise the above expectation. The Chinese government is intent on having the Chinese renminbi (RMB) added to the International Monetary Fund’s (IMF) reserve currencies. The status of the RMB as a reserve currency is a vote not just for the absolute economic strength and viability of China, but also for the relative strength of the country. The Chinese government, then, is inherently interested in the addition of the RMB to the IMF’s reserve currencies.
Much similar to the adage, “don’t count your chickens before they’ve hatched,” China cannot afford any development which threatens to derail the IMF’s view of its financial viability. Unsurprisingly, then, the Chinese government has been hard-pressed to maintain the IMF’s confidence in their national economic strength. Until the recent spike in market volatility, the global economy didn’t have much to go on when analysing the reactionary capabilities of the Chinese government. Now we do.
Upon the release of catastrophic Chinese July 2015 export data, which clocked in at a decline of 8.3% vis-a-vis an expected decline of 0.8% according to Trading Economics, financial market volatilities spiked. Worries were further exacerbated when Chinese economists forecasted the country to remain squarely on-track to meet its 7% GDP growth target. In the ensuing chaos, the Chinese government imposed various command-and-control restrictions on borrowing, short sales, and even liquidation — people weren’t allowed to pull out their money, at a time when so many wanted to. Stock exchanges were temporarily closed, and the Chinese government cumulatively injected over $1 trillion (that’s twelve zeroes) into the capital markets.
As revealed by the Chinese government’s reactions in response to the volatility spikes, the country is willing to take hard-line measures to keep the financial system afloat, even if it means freezing or maintaining artificially-high prices. Regulations like the above, however, don’t often last long, and when regulations in China that prevented liquidation were loosened, the sell-off enthusiastically resumed.
The U.S. rates predicament
On the other side of the world, the U.S. faces a problem of quite a different nature from that of China, albeit it is a problem that affects all countries around the world. Since the subprime mortgage crisis of 2007-2009, U.S. interest rates have remained at extremely low levels — currently, they stand at around 0.25%. This level of rates was brought about by the Federal Reserve System’s quantitative easing, which involved the unorthodox purchase of long-term bonds, flooding the markets with enough money to ride out the crisis.
The financial system has since shaken off the crisis, with investment banking and other heavily-hit sectors back up at record growth rates. Though the real sector arguably has not benefited nearly as much from the quantitative easing (you could make the argument that they didn’t get anything — they mostly just paid for the plan), the U.S. economy is nevertheless in a better state than before the crisis.
The Fed is now left with the part of the plan that arguably entails the hardest execution: the exit plan. With U.S. interest rates at such low levels, the Fed cannot afford to have the U.S. economy “reset,” with expectations of interest rates getting too used to the current low levels. They will eventually have to raise rates. When this should happen is a matter of intense contemporary debate. Many economists, investment banks, and other institutions assert that mid-2015 is not the right time. Others think the right time has already passed, and that any rate hike is simply a form of catch-up.
The problem with a rate hike is that it inevitably curtails the growth prospects of businesses. Costs of debt (and, with them, costs of capital) rise, and the currency experiences appreciation pressures which, in turn, hit net exports. The net effect is that, on the aggregate, businesses’ bottom-lines will be adversely affected. This worry has caused, and continues to cause, severely sharp outflows from the U.S. stock markets.
In China, we have a country experiencing a debilitating slowdown, with government regulations opaque and controlling enough that you wouldn’t be wrong to worry about your ability to sell, even as an individual, retail investor. Long story short: when given the chance, people had a tendency to pull out of the Chinese markets.
Over in the U.S., the possibility of a rate hike which could painfully dent company bottom-lines has investors hesitant to enter the market. An already-appreciating dollar — which itself hurts exports — adds even more fuel to the fire, as a rate hike would do nothing to curtail this, and will just cause more appreciation pressure. Long story short: you wouldn’t have much incentive to put your money in the general U.S. markets right now.
Now let’s put these two analyses in perspective: when the two largest economies in the world fail to give you any incentive to put your money into their markets, where would you go? Further, where would you go if you expected a further increase in global markets’ already-heady volatilities? Many of these thoughts are running through investors’ minds, and so far, the answer has been to put their money in safe-haven markets like Japan.
With global market volatilities at such high levels, investors around the world are cautious about the countries wherein they put their money, and so long as Chinese policies remain so opaque and controlling and the Fed remains indecisive about its monetary policy, this caution would be well-justified.