China, Greece and that first US rate hike – not like 1994…
Despite the China-inspired plunge in equities, concerns about Greece, and imminence of the US Fed’s first rate hike since June 2006, global growth should not be derailed. But, it needs China to act.
China’s 3% renminbi devaluation confirmed for markets that China is slowing. Based on the data we see, they should really have known this. But, two risks now are the extent to which high retail leverage behind China’s equity positions dents the economy, and the potential deflation flow (via falling commodity prices and cheaper Asian exports) back to the G7. These need monitoring.
China’s attempts to tackle the symptom failed. It now needs to address the problem…
Yet, the scale of the devaluation is puny, compared with the last, one-third yuan devaluation of January 1994. This preceded by a month the surprise start of the US Fed’s rate tightening cycle, which have together been blamed for originating 1997’s Asia crisis. Germany at that time was struggling to shake off its 1992-93 recession.
With China again devaluing, the Fed about to tighten, and the euro-zone unfixed, little wonder competing Asian currencies are weakening and equities held back. However, we doubt the extra volatility will be enough to spur the market “turmoil” akin to either 1994 or 2008 needed to push G5 central banks off course.
First, China still has a ‘dashboard of policy buttons’ to press to help achieve a soft landing. Their direct attempts to tackle the symptom (falling stocks) have so far failed. It needs now to address the problem (slowing economy).
The authorities were never going to allow the RMB to climb indefinitely (as it had been in real trade weighted terms) at a time when GDP’s slowing and China’s competitiveness is collapsing. We estimate that, after double-digit growth in 2000-11, China’s productivity froze, then fell about 7% in 2014 (see my chart, below). Worryingly, the latest up-tick (in Q4 2014) reflects job cuts more than output growth.
Therefore, big incentives remain for the PBoC to shore up the economy. Expect further policy stimulus – ranging from reserve requirement cuts, tax-breaks for SMEs, subsidies, infrastructure spending, ad hoc liquidity injections, and (with real lending rates still about 4%) further rate cuts. Added to that, the official regulator, CSFC could inject more for share support, and there’s scope for a fiscal boost. And, should local debt-strains intensify, PBoC could always run QE.
Comparisons with 1994 look superficial…
Second, the G5’s growth ‘front-runners’ – the US and UK – appear to have enough growth momentum to weather the cold winds from China.
Each is six years past crisis, with their GDP running above 2%yoy ‘potential’, and CPIs set to show some uplift. Given the US’s insulation (only 1% of US GDP comes directly from China’s export demand), the fall of unemployment into the Fed’s 5¼-5½% ‘Nairu’ range, and declining labour supply, US hikes could start in December. For the BoE, its single, CPI mandate makes a rate hike difficult before May 2016.
Third, comparisons with 1994 – when the Fed’s surprise tightening hit most financial assets – look superficial. That was a different time. China’s devaluation was huge, based more on reform than growth, but pressured Asian competitors to whittle away reserves to protect their own currency pegs. The only meaningful peg now is Hong Kong’s, which should benefit from a weaker renminbi. In 1994, the Fed was more worried about ‘overheating’ than ‘normalisation’.
Now, central banks have too much ‘skin in the game’ to want to take us off guard, with the Fed running $3 trn excess reserves. Unless policy shifts are clearly telegraphed, they may feel our pain.
However, relative to China, Greece’s policy position – unable to devalue externally, boost fiscally, and print money – and growth outlook look more acute. Our base case has long been Greece remains in the euro (partly because of the pitfalls of exit, and incentive of QE), but, that a debt restructuring is both inevitable and desirable.
Done well, it would allow Greece to lock into current low funding costs and reduce the floating rate element of its debt service payments. It would reduce uncertainty, and put the onus on meeting primary-surplus targets more via growth-induced tax revenue, than austerity.
However, political risk is a growing danger as we approach general elections, not just in Greece, but in Portugal, Spain, and maybe Italy. To minimise this, it probably makes sense to defer a ‘generous’ Greece restructuring to sometime in 2016.
Meantime, China is taking advantage of its greater options by slowly cutting rates and massaging down the renminbi, and by again using the guise of reform to drip-feed some relief to growth.
The challenge now is to enact an avalanche of stimulus measures sufficient to arrest the decline and avert market turmoil. If they don’t, the Fed’s tightening cycle could prove to be one of the shortest yet.
Neil Williams is chief economist at Hermes Investment Management