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Ireland's political and cultural magazine
18September/October 2015
S
TOCK and bond markets have been rocked on
the waves of volatility, the doom of deep cor-
rections and the highs of rapid reversals. The
summer of will go down in history
books as a period when the markets have
finally reverted to pricing in real fundamentals. And the
process of market ‘normalisation’ is proving to be a dis-
ruptive one.
After years of living on the hopium of endless easy
money pumped into the economy by central banks and
governments, the markets have finally started to
embrace reality: in the eighth year of the fabled global
recovery, economic growth around the world is
faltering.
‘China Tremor’
The August bear correction in the global markets was
not the first alarm for investors. And it won’t be the last.
The first signs of a deep rot in the global economy
registered as the - move by investors out of
Emerging markets and a dramatic uplift in demand for
lower risk assets, such as Government bonds. By mid-
, clouds over emerging markets had spread to
corporate bonds, with flash sell-offs and increased vola-
tility hitting lower-grade junk bonds. The storm rolled
on to the commodities markets with
oil setting into a precipitous decline in
mid-, followed by other indus-
trial commodities and agricultural
staples.
By early , there were tremors
hitting European Government bonds.
Currency valuations shook. In May-
June, a wave of volatility hit the
sovereign bond markets, as ECB pur-
chases of Government paper resulted
in a dramatic widening of spreads and
the fear of markets seizing up. Corpo-
rate debt caught the flu with dramatic
increases in risk assessments for
global corporate bonds.
All along, trouble was brewing in
the Far East: global trade was falling
off the cliff, largely unnoticed in the
mainstream media. The Chinese
growth engine was stalling and the
Asia-Pacific region was swept by repeated rounds of
currency devaluations.
Finally in August a massive blowout in stock markets,
triggered by a collapse in Chinese shares prices, drove
panic across both the advanced economies the emerg-
ing markets. On August th, after weeks of historically
anomalous volatility, the Shanghai stock exchange fell
almost percent, with the Nikkei, EuroStox and
S&P all erasing on average just under % of their
valuations.
By the end of the month, massive volatility in the
markets around the world pushed share prices into
recovery. Still, Shanghai was down percent, the US
S&P was off . percent, Japan’s Nikkei shed over per-
cent and the EuroStox index was . percent lower.
At the time of the market nadir, global equity falls
had erased some $.tn of paper wealth. All in, August
ended with the S&P down % marking the largest
monthly drop since May ; the EuroStoxx had fallen
.%, the index’s worst performance since . The
FTSE is down around % while the
ISEQ lost next to nothing.
Market turmoil was so sharp that
the VIX index, a gauge of investors
fear, reached its highest level since
at the end of August, while a
broad basket of agricultural and
industrial commodities hit its lowest
level since the start of the century. Oil
dropped to its lowest level since ,
down almost % over the last
months and % since June’s high.
Copper hit a six-year low on August
th.
China’s devaluation of its currency
on August th sparked forest fires
across the market. Contagion quickly
spread to its core trading partners,
such as Japan, South Korea, Indonesia,
Malaysia and Singapore. Having
devalued the yuan by some percent
overnight, the Chinese authorities made matters worse
by subsequently aggressively intervening in the mar-
kets, selling US dollars and buying Chinese stocks.
All told, estimates from market analysts suggest that
China sold more than $bn worth of US Treasuries to
partially fund foreign exchange interventions and
stockmarket support measures, within just two weeks
between August th and August th – more than it
Any country
dependent on global
trade should be
very afraid
No market is an island
Constantin Gurdgiev
OPINION
INTERLOPER
In 2002 emerging
markets’ rate of growth
was 2.75 percentage
points higher than
advanced economies’.
By 2009 it peaked at
6.5 percentage points
but is down to just 2.1
percentage points this
year
“
no economy is an island
September/October 2015 19
A hard landing in China will rival the impact of the
US Great Recession on the global economy
”
did in the previous eight months combined. This put
fear into the $ trillion worldwide bond markets: as
equity investors rushed into the safety of US bonds, sell
orders were flooding in from the largest international
holder of Treasuries, China.
Some Financial Lessons to be Learned
The ‘China Tremor’ taught us several valuable lessons.
The first one was that global investors should not
count on Chinese authorities to mind international mar-
kets corner.
Throughout the entire crisis, Beijing’s sole concern
was, and remains, insulating the Chinese economy from
spillovers from market turmoil. In the process of pursu-
ing this goal, China is willing to go to currency war, as
well as deploy a range of measures aimed at curbing
trading that cuts across its objectives.
The second lesson is that Chinese markets – no
matter what their direct impact may be on individual
economies – are systemic to global finance.
In a sign how interconnected the markets and inves-
tors’ strategies are in modern financial environment,
consider the following dynamic. When Chinese authori-
ties started selling US Treasuries to defend the yuan,
many institutional investors worldwide were holding
so-called risk-parity portfolio positions. This strategy
involves borrowing heavily to invest in low-volatility
assets, such as advanced economies’ Government
bonds. The return to such bonds tends to countermove
with stocks returns, so booming stock markets imply
shrinking bonds returns. But leverage (borrowing)
allows investors to bring their profits closer to those
that can be earned by holding much riskier equities.
Thus, at the end of August, many institutional inves-
tors worldwide were banking on a continued negative
correlation between stocks and bonds returns, along
with low volatility in bond prices.
Once China started selling US Treasuries, three
things happened: bonds prices moved down in line with
falling share prices; bond prices became more volatile;
and leveraged funds were forced to cover mounting
losses. A sell-off of risky assets across global markets
ensued to cover the latter.
The third lesson is a forward-looking one: given the
Chinese Government’s commitment to support eco-
nomic growth, the pain of the Chinese economy’s
adjustment to the new realities will be borne by China’s
trading partners.
The problem here is that the only way China can con-
tinue supporting its economy and domestic stock
markets is by abandoning its defence of the yuan. This
means that the recent yuan depreciation is just the
beginning of a longer and more painful process of
competitive currency devaluations across the Asia-Pacific region, and beyond. And that will
result in renewed deflation in commodities prices around the world, and the associated
deflationary pressures.
The realisation that this is the likeliest scenario is behind the miraculous ‘recovery’ in the
advanced economies markets since the end of August. Before the Chinese market collapse
roughly - percent of global investors were expecting the US Fed to start hiking rates in
September-October this year and for the ECB to end its Quantitative Easing (QE) around the
third quarter (Q) of . Following the ‘China Tremor’, the percentage is now closer to
. Western investors are increasingly projecting a Fed rate hike to come in December or
later, while there is emerging talk in the markets about the ECB extending and expanding
its QE.
Which brings us to the main lesson from the August blowout: no market is an island. This
lesson remains alien to EU authorities which were making outlandish claims during the last
days of August that Europe had erected functional ‘firewalls’ against global market conta-
gion. The complacency was exacerbated in Ireland by Government and media effectively
sleeping through the May-August period of volatility.
It’s the Economy, Stupid
Following relative calm in the markets in the first days of September, investors have been
trying to gain some understanding of the August sell-off. Much of the analysis agrees: a
hard landing in China will rival the impact of the US Great Recession on the global economy.
Even usually out-of-touch Irish politicians are staying pretty silent on the prospect, if
they’ve noticed it.
For China, ‘hard landing’ implies economic growth falling - percentage points below
the percent average annual expansion target for - set by the Chinese authori-
ties. While official figures from Beijing suggest the economy is likely to achieve growth in
the range of - percent this year, many analysts are arguing that it is already at the ‘hard
Chart 1: Troubled Companies Index signals uptick in corporate default
risks worldwide
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Source: Kamakura Corporation
20September/October 2015
landing’ mark.
The reason why such an outcome is likely to spell
trouble for emerging markets and advanced economies
is that recent global growth trends have been heavily
reliant on Chinese demand for either inputs into pro-
duction (raw commodities and semi-finished inputs,
capital goods and technology, financial capital and pro-
fessional services) or finished goods.
For example, in , the top ten luxury-brand hold-
ing companies in Europe relied on China for roughly one
third of their global sales. Chinese buyers accounted for
up to percent of global sales for some European
brands, such as Swatch. Over percent of Apple’s
smart watches are sold to Chinese customers.
Simply put, China has been one of the core drivers of
global growth over the last two decades, and the domi-
nant one since the onset of the Great Recession in late
.
Zooming in to the present, Chinese exports have been
falling in recent months, just as China’s imports from
neighbouring countries have fallen through the floor.
South Korea – the world’s biggest exporter to China
– saw its factory shipments to its neighbour collapse
percent in the year to August , marking the eighth
straight month of declines. South Korea supplies capital
and intermediate goods to China, so a collapse in its
exports is an unambiguous sign of a rapid slowdown in
Chinese manufacturing.
To make things worse, the Chinese economic slow-
down is not an isolated event. For example, based on
Purchasing Manager Indices (PMIs) – a gauge of manu-
facturing activity – the Chinese economy has been stuck
in a growth soft patch since late . The start of the
latest bout of outright contraction in the sector can be
dated back to Q . Meanwhile, the services sector,
stripping out financials, has also been lugubrious since
around Q .
Over the seven months from January to July ,
composite PMIs for BRIC economies (Brazil, Russia,
India, China) imply virtually zero growth in the world’s
largest emerging markets. Back in emerging mar-
kets’ annual rate of real GDP growth was about .
percentage points higher than that in the advanced
economies. By the growth gap peaked at . per-
centage points. Ever since then, the emerging markets
growth premium has been on the decline, dropping to
roughly levels in . The gap is expected to end
at just . percentage points this year.
Brazil and Russia are now in official recessions. As are
Indonesia and Canada. South Africa is one quarter away
from entering one. Switzerland avoided a recession this
year only by squeezing miraculous .% growth in Q
. According to a growing number of analysts, Aus-
tralia is heading for a recession.
Drivers for this development are multiple, but
amongst the most important ones are the following:
• Weak consumer demand in Western economies,
where recovery has been driven primarily by the
nancial assets boom, rather than by domestic
demand (consumption and investment) growth;
• Rounds of QE-induced devaluations of core curren-
cies, such as the US dollar, euro and Japanese yen
have triggered currency wars across the world
• The prospect of higher US interest rates is weighing heavily on the global economy.
Propelled by the above factors, Emerging Economies’ currencies have now fallen to their
lowest levels in over years, resulting in a precipitous decline in the dollar value of bonds
and stocks denominated in these currencies. Hence, the broad MSCI index of emerging
OPINION Constantin Gurdgiev
September/October 2015 21
markets shares is now down roughly percent on
, while advanced economies’ markets indices are
up, on average, by some percent. Based on data from
Bloomberg, emerging markets are trading at a per-
cent discount to developed markets, the largest gap in
years.
The prospect of the US Fed reversing its policy and
raising rates is a daunting one for the global economy.
Between and , historically lower interest
rates in the US and Japan fuelled significant capital
inflows into emerging markets. The series of currency
crises in the second half of the s unwound some of
these excesses. Subsequently, from the end of
until early , a large credit bubble in the G econo-
mies (the US, Japan and the Euro area) pushed more
investment into t emerging markets.
Starting in July , the new era of exceptionally
low interest rates has reinforced this trend. As Western
investors borrowed in their home markets to invest in
developing economies, their returns became fully
underpinned by what is known as carry trades. In a
classic carry trade, an investor borrows at low interest
rates in her home currency and invests in a higher-in-
terest-rate currency-denominated assets abroad. As
long as the investment generates real returns in the
home currency that are greater than the cost of borrow-
ing, the investor remains content. However, if the home
currency strengthens or domestic interest rates rise,
the carry-trade investment becomes exposed to a risk
that the investor will not be able to
repay the original loans.
What we have now is a combination
of a decline in market returns on top of
the classic currency risk involved in a
carry trade compounded by the pros-
pect of US rates moving up. The result
- trillions of dollars worth of invest-
ments raised through carry trades are
now at risk.
The Key to the Future
The key question, therefore, is whether
or not China is set for a deepening eco-
nomic crisis or if the recent markets
tumult was a temporary correction.
On the surface, the Chinese economy does face severe
problems, with external trade taking a beating, while
the domestic economy is weighed down by rapid accel-
eration in non-performing debt and slowing domestic
investment.
The good news is that Chinese stock markets have
little connection to real economic fundamentals on the
ground. Chinese share values amount to just under one
third of the country’s GDP, a third of the weight of
advanced economies’ equity markets in their domestic
economies. Over the months to June , Chinese
stock prices nearly tripled in value, just as the real econ-
omy was running along the weakening trend.
Stock-market-related lending had been rising very rap-
idly before August, but it still only amounts to percent
of the country’s total banking assets.
The real trigger for a Chinese economic ‘perfect
storm’ will more likely be the country’s property markets.
Just as in Ireland in , in China today property accounts for virtually all collateral
against which the sizeable mountain of household and corporate debt has been extended in
recent years, reaching as high as % of the country’s GDP, double what
it was just eight years ago. To make matters worse, house prices have been
rising, not falling, amidst the financial markets’ rot.
New construction and broader real-estate investment have nowhere to
go but down, as developers and banks are sitting on massive inventories of
unsold properties. Outside private investments, local authorities’ debt
that ballooned in recent years is holding down public investment in
infrastructure.
Central Government budgetary dynamics, however, suggest that there
is substantial room for fiscal policy supports in the months ahead. For the
full year, Beijing was originally planning on a fiscal deficit of . percent of
GDP. So far, in the first seven months of the year, it has been running a
fiscal surplus. This means that the central Government has sufficient
funds to significantly ramp up public spending into Q .
Monetary policy offers further room for manoeuvre. Despite a number
of cuts through the end of August, the benchmark -month lending rate
is still high at . percent, as compared to virtually zero in Western economies. Chinese
banks are required to have a reserve deposits ratio of percent, as opposed to around
percent for the majority of Western systems.
In the longer term, China can pursue serious reforms - in goods and service markets,
public services and investment, labour markets, regulation, and so on. The list of reforms
overdue is longer than that for Greece.
But, the key point of the markets’ performance over the summer flows well beyond the
country’s financial and economic borders. They are a reflection of the global economy’s
poor health.
China has just completed several decades of growth fuelled by investment. Capital forma-
tion and the build-up of physical infrastructure has accounted for roughly half of Chinese
GDP growth over the past two decades.
Today, this means surplus capacity, as global economic growth cannot sustain all the
machinery, factories, land and resource reserves accumulated by China, but also by a
number of other states, including Australia, Canada and even the US.
Any country, like Ireland, heavily dependent on multinational investments and exports
should be worried. •
The problem here is that
the only way China can
continue supporting its
economy and domestic
stock markets is by
abandoning its defence of
the yuan
“
Source: Author’s own calculations based on data from the US Federal Reserve, ECB and Bank of Japan
Chart 2: G3 policy interest rates
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