The China Syndrome

The Wikipedia entry for the 1979 film The China Syndrome states that it “tells the story of a television reporter and her cameraman who discover safety coverups at a nuclear power plant”. It is not, of course, set in China – it is in America – but in the worst case, the nuclear meltdown would travel through the earth supposedly all the way to China.

Financial markets have experienced their own form of meltdown over recent weeks. On this occasion, the proximate cause emanated from China itself. Markets were already in a slightly fragile mood as a result of growing concerns over the implications of an impending tightening in US monetary policy (on this front, I believe that the first steps towards policy normalisation should be regarded positively – not as a cause for concern). But it was a worry over the health of the Chinese economy and financial markets that eventually triggered some of the sharpest one-day falls in markets seen for some years – in the case of the UK’s FTSE 100, since March 2009.

The problem with regard to China is in knowing exactly what is going on. We do not trust the data, because we suspect it is being manipulated (I do not trust quite a lot of data in the UK either, but here the problems are more to do with statistical incompetence); and, we have an incomplete understanding of policy objectives. So, when China announced a new currency regime, how was this to be interpreted? Ostensibly, it was a move towards liberalising the market in the yuan in order to make it more acceptable for inclusion in the IMF's special drawing rights ‘basket’. However, there was more than a suspicion that the timing of the announcement, at the very least, was designed to bring about a gradual realignment downwards in the yuan.

Meanwhile, although the second quarter growth number for the Chinese economy of 7% remained bang in line with the official target, most economists have been lopping off at least 2% when trying to assess the ‘true’ growth rate. Although even 5% sounds exciting in western terms, in China’s growth model it is probably not sufficient to prevent employment rates declining. In other words, the economy will display recessionary traits, albeit growth is positive.

The immediate impact of the deceleration in growth has been on commodity markets. The problem here is that, against the backdrop of many years of heavy investment in production, world growth is simply not strong enough to absorb current supply potential. Hence, stocks have been rising and prices have been soft. It is not so much that the world has not been growing; rather it is becoming evident that ‘normal’ growth rates are some way below those recorded during the decade prior to the recession. As one of the world’s major importers of energy and raw materials, China had helped to maintain a semblance of equilibrium. But with the economy there losing momentum, commodity prices began to fall. This was most obvious in the oil market, which has had to absorb the additional supply shock of rising US output.

So, it was tumbling commodity prices that rang the alarm for equity investors. Against the backdrop of quieter summer turnover levels in western financial markets, conditions were perfect for a dramatic sell-off. The newspapers would have you believe that investors were in a frenzy, queuing to place their sell orders. But this is far from the truth. Even modest amounts of selling (added to some activity from high-frequency traders) will be sufficient to drive prices sharply lower when there is an absence of buyers. Ironically, actions taken by the authorities in the aftermath of the financial crisis that restrict the capital that investment banks can commit to holding in inventories of securities exacerbates the extent of price declines in such a situation.

So where does this leave us? My core economic view has not changed. So far as the UK and US are concerned, both economies have developed decent momentum, albeit trend growth will likely remain slower than the rates recorded in the pre-recession period. Meanwhile, conditions in the eurozone are gradually improving, but there remains a question mark over Japan. This adds up to growth of around 2%, or slightly above, in developed economies. Developing economies will grow faster, but not fast enough to recreate their pre-recession success. The conundrum is how they adapt to slower growth in export markets without damaging each other. In particular, the reaction of the Chinese authorities to the slowdown in its economy could be highly disruptive within the Asian region.

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