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China has attempted to transition its economy from an easy credit, heavy investment driven country, to one driven by domestic demand and consumer spending.

An externality of this effort was seen earlier this week as the People's Bank of China allowed short term interbank rates to spike. They are making a concerted effort to end easy credit, thus also diminishing the chances of a speculative bubble in real estate to occur.

There is a fear that the PBOC's policy adjustment is tapering growth and GDP is likely to trend lower as it has since the beginning of the financial crisis.

Below is a chart of iShares FTSE China 25 Index Fund (FXI) over Vanguard Total World Stock Index ETF (VT). This chart highlights the relative weakness China has faced since shifting policy motives. Lower growth and a falling Chinese equity market led to weaker demand for commodities and weakness in commodity driven currencies.

Similarly, emerging markets, who derive a large share of revenue from exporting raw materials to China, have seen declines due to a weaker China.


(Click to enlarge)

Below is a chart of iShares MSCI Emerging Markets Index (EEM) over Vanguard Total World Stock Index ETF, which looks eerily similar to the chart of China versus world equities above.

A weak China, as well as a stronger U.S. dollar and tightening credit markets have pushed funds out of emerging market assets. Emerging markets had been in a steady decline due to the artificial nature of their nominal rise; however, with Ben Bernanke signaling an end to monetary stimulus earlier last week, emerging market equities spiked lower.

A weaker global inflation outlook has weighed on commodities, and the lack of developed market economic growth has suppressed GDP numbers. Until the world can truly recover from the economic slump created by the financial crisis, China and emerging markets will continue to underperform.


(Click to enlarge)

Source: A Weaker China Weighs On Emerging Market Equity