FORGET "TAPER" RISK : CHINA IS A BIGGER THREAT / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

August 6, 2013 9:56 am

 

Forget ‘taper’ risk: China is a bigger threat

 

By George Magnus

 

Deflation looms as Beijing rebalances economy

 

 

Developed country equity and credit markets snapped back quickly after the Federal Reserve tapering wobble a few weeks ago. From the crow’s nest, markets have accepted that Fed policy normalisation will be gradual, become more confident about economic prospects, and put to one side earlier concerns about the risk of deflation. At the coalface, though, things look more nuanced, and suggest that Fed tapering is much less of a risk than rising concern over a ‘fin de siècle’ moment in emerging markets, especially China, which could spark new deflation fears.

 

Sincé early May, the top-performing equity markets have been the US and core Europe, putting Japan and southern Europe in the shade. Nearly all developed market indices are outgunning emerging markets, which have lost almost all the gains made from last summer to January, and the continuing slide in commodity prices is undermining countries such as Australia and Brazil.

The tapering announcement, expected after the September meeting of the Fed’s Monetary Policy Committee, has already been well discounted, with US 10-year government bond yields up by nearly 1 percentage point since June. Markets know there is a country mile between tapering and a reversal of quantitative easing, let alone a rise in policy rates. That said, some uncertainty remains about the behavioural consequences for investors, banks and borrowers as the monetary policy regime of the past four years starts to change.

 

Elsewhere, although the Japanese government is expected to confirm in October the planned two-stage consumption tax increase, starting next year, Europe is a bigger cause for concern. Claims that recent economic indicators portend a return to sustainable growth in southern Europe look way off the mark, and are overshadowed by the absence of aggregate demand, the unsustainability of debt levels and default risk, and the difficult politics of austerity.

 

Moreover, the new German coalition government, emerging after next month’s elections, is most unlikely to accede to demands for a change in Germany’s macroeconomic policies, or for the transfer mechanisms and fiscal backstops needed to build a credible banking union, and a more stable European banking system.

 

But the most immediate and transparent threat to markets is already evident in the funk in emerging market equity, local currency bond, and currency markets, as well as in global commodity markets. Predictably, China is centre stage.

 

It has already figured prominently in the economic forecasting industry’s downgrades, but there is a still a way to go. Analysts and investors have not yet embraced fully the idea that the China problem is not about a cyclical and easily countered economic detour, but about the implications of what a fundamental transformation of the country’s economic model means for China’s GDP growth and supply chains, and for global commodity markets and industries.

One way or another, the model is going to change. The role of physical capital formation will fade as the economy rebalances.

Physical labour input has been more or less exploited, and the credit intensity of GDP growth has to be brought down. China’s top leaders understand this, but changing the model to one based on efficiency, innovation and a greater role for markets at the expense of the state, is easier said than politically done.

Even if they succeeded, making the change could only be done in the context of slower, sustainable growth, and policies designed to absorb or address overcapacity in heavy and commodity-intensive industries, and a rise in debt service problems, defaults, and non-performing loans.

This comprises an unequivocally deflationary risk for global markets, which is likely to challenge risk appetite again and push up the US dollar, especially against emerging market currencies, including even the renminbi.

In China, the GDP deflator (a measure of the level of prices of all new, domestically produced, goods and services in an economy) has already slumped to a reported annual rate of 0.5 per cent in the June quarter, from around 7 per cent just two years ago. The combination of overcapacity in several industries and weaker growth could generate further downward pressure on Chinese goods prices at home and abroad.

Industrial and mining commodity exporters face a daunting time as the share of property investment in GDP falls from a lofty 15 per cent. The income and wealth effects on sectors from steel and cement to white and luxury goods could affect up to 35-40 per cent of the economy. Against this backdrop, concerns about tapering are little more than the proverbial rounding error.


George Magnus is an independent economist, and senior economic adviser to UBS
 

Copyright The Financial Times Limited 2013.