If Brexit and wobbly Italian banks weren’t enough to worry about, another major economic risk, that of deflation, is only getting worse. The Telegraph’s Ambrose Evans-Pritchard has warned for some time that if China were to devalue the renminbi, it would add considerably to already dangerous deflationary pressures.
It’s not surprising that China would reduce the value of the renminbi vin the wake of the Brexit vote as the pound has plunged and the euro has weakened. in 2013, the EU was China’s biggest export market but by 2015, it had fallen to its second largest market, which could make Chinese officials concerned about further erosion of their position. As Evans-Pritchard stresses, the Chinese are presumably using the furore over Brexit to execute this move when officials are distracted.
But the rationale for this measure is to shore up an unsustainable mercantilist growth model. As many analysts have stressed, China has for years has had investments and exports consist of an unheard of level of over 50% of GDP. China desperately needs instead to have a much larger consumption share of GDP. But in the wake of the criss, it instead ramped up investments that have been mainly funded by borrowing, with the boost in GDP from each dollar of borrowing falling over time. So the investment-driven model is nearing its sell-by date, yet the economic mandarins are doubling down.
And as Evans-Pritchard outlines, the result of this last-ditch effort to preserve Chinese growth will be to kill its export markets. Germany, the world’s other relentless exporter, is achieving a similar result by insisting on running trade surpluses, refusing to fund its counterparts (which is inherent to running trade surpluses) and insisting that the problem is that their partners aren’t competitive enough and inflicting crushing austerity and labor-squeezing policies on them.
Evans-Pritchard also highlights that China’s policies are fueling protectionist backlashes. And the reason the responses may wind up being extreme is that we failed to take more measured steps years ago. As William Greider has been pointing out for years, our form of globalization is one of managed trade, not “free” trade. The US has allowed our trading partners to structure arrangements that allowed them to protect their workers and run trade surpluses (or at least avoid trade deficits) at our expense. The US Treasury has also failed to deem China a currency manipulator in its semi-annual certifications even though there have been periods when the designation unquestionably fit. The big reason for sitting pat was geopolitical: China made clear that it would regard that move as provocative and the implication was that they would retaliate. But now with China taking an aggressive stance in the South China Sea, some confrontation a decade ago might have forced a realignment. Now the political and economic stakes are vastly higher, leaving virtually no room for error. And the default of letting China continue on its current path is certain to end badly.
China has abandoned a solemn pledge to keep its exchange rate stable and is carrying out a systematic devaluation of the yuan, sending a powerful deflationary impulse through a global economy already caught in a 1930s trap….
Mr [Mark] Williams [of Capital Economics]said it is unclear whether Beijing intended to deceive investors all along when it gave categorical assurances earlier this year, or whether it is feeding on events….
Factory gate prices within China are falling at a rate of 2.9pc, further amplifying the deflationary impact. Analysts fear that Beijing is engaged is an undeclared policy of beggar-thy-neighbour mercantilism, trying to avert an industrial crisis at home by exporting its overcapacity in steel, shipbuilding, chemicals, plastics, paper, glass, and even solar panels, to the rest for the world.
“When you have a relatively closed capital account like China, it means that any currency move like this is a policy decision,” said Hans Redeker, currency chief at Morgan Stanley.
“They seem to be overriding their own model and letting the remnimbi (yuan) fall to improve competitiveness. They are in the same sort of deflationary syndrome as Japan in the 1990 but on a much bigger scale. The global economy is in no position to absorb this.”
Import prices in Japan have collapsed by 20pc over the last year, 5.5pc in Germany, and 5pc in the US, despite the recovery oil prices. Mr Redeker said China’s attempt to export its problems though devaluation is a key reason why inflation expectations are crashing to record lows across the developed world.
This in turn is driving bond yields to historic lows almost daily, with 10-year borrowing costs down to -0.58pc in Switzerland, -0.28pc in Japan, -0.16pc in Germany, 0.14pc in France, 0.78pc in Britain, and 1.4pc in the US…
The latest twist comes from the foreign reserves data, which suggest that China may have begun to intervene actively in the markets to drive down the yuan. This would have grave repercussions. Provisional figures imply that the PBOC purchased a net $34bn of foreign bonds in June, once valuation distortions are stripped out.
As we have also warned, ZIRP and negative interest rates are destructive to banks, life insurers, and pension funds. Both the real economy and financial assets suffer in deflation. Despite lofty-looking valuations now, a financial asset is someone else’s financial liability. Many of these claims will be marked down as businesses and households struggle under sustained low growth-recessionary conditions.
The economist Herbert Stein said, “If something cannot go on forever, it will stop.” However, China has made an art form of defying Stein’s saying. And every major economy that has moved from an export-driven model to a consumption-driven one has suffered a major crisis. There are thus good reasons to expect things to end badly, but when is anybody’s guess.