Remember last year (August 11 to be precise) when world markets suddenly went into a funk because the Chinese yuan devalued a bit? Actually, this was just a stunted move to make the exchange rate a little more receptive to market forces in a bid to qualify the yuan as a reserve currency (part of the IMF SDRs, Special Drawing Rights, a synthetic currency). China achieved this earlier this month.
As you can see, even the US market sold off markedly in response to this. Things calmed down after there was no further significant lurch downwards of the yuan until the end of the year.
Then, we "enjoyed" a re-run of this scare when large capital outflows from China provoked the Chinese central bank to unprecedented support interventions in which it lost $80-100B in reserves a month.
It seemed at the time that this couldn't continue and the yuan was about to go a whole lot lower. This would have dire consequences for a world already teetering on the brink of deflation, not to mention China itself where companies raked up in excess of 1 trillion in dollar-denominated debt (as did many companies in emerging markets).
The foreign currency interventions were also automatically tightening domestic liquidity in China, which could sink the non-tradable and especially the property sector.
The fears have actually been overblown. The capital outflows were at least partly a reflection of Chinese companies paying off their dollar debt, so this was more of a one-off and the capital outflows abated to more manageable levels. As China still enjoys a considerable current account surplus, the Chinese foreign currency reserves stabilized.
As calm returned, China embarked on another round of easing which propped up the economy, especially the property sector. Basically, the strategy seems to grow into the huge excess capacities that exist in many of its heavy industries, most notably steel.
With luck, it can actually pull this off and avoid a wholesale rationalization of the heavy, largely state-owned industry. It's not hard to see why it tries. A wholesale rationalization would amount to millions of job losses which could ultimately threaten the legitimacy of the state and the social stability stuff to be avoided at all cost.
There are signs that it is indeed succeeding. A data point that hasn't received sufficient interest in our view is the end of Chinese producer price deflation (Market Watch):
"China's long battle with industrial deflation turned a corner last month as a gauge of prices for factory output turned positive for the first time in more than four years. China's producer price index edged up 0.1% in September from a year ago, the government reported Friday, marking the first time the index was positive in 54 months. The index had fallen by 0.8% in August."
Indeed, 54 months of, well, considerable deflation:
It's doubly good news. First, it is a sign that the deflationary forces in China are abating, at least for now. It's too early to say whether it's just a product of the latest stimulus measures and will peter out with these.
Secondly, this makes the slow decline of the yuan a whole lot less scary for the rest of the world. Lower factory prices combined with a lower yuan could potentially throw the rest of the world into a deflationary vortex from which it is difficult to escape.
However, we're now facing a gentle decline of the yuan, but factory prices are no longer declining at 5% a year. This is a lot less scary, which is probably why global markets have taken the slide in the yuan in their stride.
There are still those that see large Chinese risks out there though. ZeroHedge tries to scare us with a whole series of declining yuan and other asset correlations, many of which seem largely, or even entirely spurious.
Perhaps somebody should tell it that correlations do not necessarily imply any causality. Most definitely somebody should have told it that what matters isn't the nominal dollar-yuan rate, but the real rate.
Does this mean investors can embark on a sigh of collective relief and rejoice in the receding Chinese risks that were hanging over the markets? Well, yes and no. Nothing really comes free in the live of investors.
The Chinese policy mix seems to be the following:
- Boost growth in order to grow into the overcapacity in many industries.
- An ever so gentle depreciation of the yuan.
- Reform "light" as to maintain social and political stability.
The problem lies with the boosting growth part. This relies mostly on credit, and there are three all too familiar problems with that:
- Outstanding credit is already enormous, at 2.5 times GDP.
- Diminishing returns have already long set in; credit is giving ever less bang for the yuan.
- Bad debts are surging.
With regards to the latter, Fitch is particularly worried. It argues that non-performing loans are between 15% and 21% of GDP and the cost of cleaning up could reach a third of GDP.
To put this into perspective, the direct cost of bank rescues amounted to 8% of GDP in the US and UK in the aftermath of the financial crisis.
Now, before you liquidate your portfolio and hide in a bunker, Chinese banks have started addressing the problem. Whether that is sufficient is anybody's guess. It could also be that Fitch is too pessimistic.
A useful reminder is also that even those highly indebted state companies have an enormous amount of assets on their balance sheets.
A cataclysmic implosion isn't the most likely scenario, given the still considerable growth in the Chinese economy, the scope for securitization of debt and the fact that most of the banks are state owned.
But working the debt off to more manageable levels will inevitably work as a drag on growth. A Japan scenario is lurking here, reinforced by a demographical turn as well. Good job those producer prices have stopped falling. Deflation is the last China needs right now.
The near future for the Chinese risk to global financial markets has improved. Given that significant producer price deflation has come to an end, there is more scope for a gentle yuan depreciation without plunging the world into a deflationary vortex.
However, achieving this hasn't been a free lunch. China needs to step it up with debt securitization, bank funding, working off non-performing loans and rationalizing excess capacity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.