The Financial Market Correction: It’s Not Just About China

China, China, China…

The most exciting development in international capital markets in 2015 was the move towards more of a free-floating exchange rate regime in China. In early January this year, the People's Bank of China (PBoC) rattled financial markets with an accelerated depreciation. The reason? In short, capital is flowing out – and it is flowing out fast at around USD 100bn per month (source: Goldman Sachs).

The PBoC has abundant reserves to manage capital outflows from foreigners. It has a much bigger problem if the locals decide to run on the currency – and this is exactly what has begun to happen. A run by locals is one force that the PBoC’s mighty balance sheet cannot accommodate. Predictably, the authorities have responded with harsher capital controls. So what's the end game for the renminbi? I think that the authorities will take another run at a managed depreciation in the not too distant future (say, the next two-to-three months). My base case is that the authorities will continue the current modus operandi of trying a managed depreciation until the day when capital controls are so severe that they can put the currency onto a crawling peg without triggering massive capital outflows.

It is worth noting that the core of the China problem has not changed over the past couple of months: it is all about eliminating excess capacity, in particular in the heavy industries, and about rebalancing the economy away from an excessive reliance on capital accumulation and towards consumption. What has changed over the last six months is that the capital outflows have sent a strong signal to the leadership that the rebalancing needs to get underway. The leadership seemingly has responded and the elimination of excess capacity has been bumped up on the list of priorities. While the long-term implications of this are good – this is what China and the world needs – in the short term, it means slower growth. And with global interest rates pretty much at zero, the world does not need another growth headwind right now.

Global Implications of the China Debacle

The most important implication of the China debacle is that it has led to elevated uncertainty about the state of the Chinese economy. Given the importance of China for the rest of the emerging markets, this has led to an acceleration of capital outflows from emerging markets in general. The uncertainty about China has also led to a tightening of global financial conditions as greater uncertainty has led to a widening of credit spreads, falling equity prices and a strengthening of the US dollar. Does this matter? The weakening of the growth outlook for the world, not just emerging markets, indicates that it does. I expect uncertainty to continue to generate a soggy outlook for growth over the coming months.

Commodity Prices

Although it is convenient to pin the entire correction in the financial markets on China, this is probably too generous. The rut in commodities prices, particularly oil, probably carries part of the blame. What's the link between the price of oil and financial markets? Beyond the obvious observation that lower commodity prices might be caused by slower growth, lower oil prices prompt sovereign wealth funds to liquidate their portfolios in order to finance fiscal deficits.

As a reference point, the combined sovereign wealth funds of the Asian oil exporters, Brazil, Norway and Russia hold a US equity portfolio worth around $450bn (source: Deutsche Bank). The aggregate fiscal deficit of the countries in the Middle East is around $200bn according to the IMF – a deficit that grows every time the price of oil falls. Now that's a lot of stocks to sell.

Falling commodity prices have other profound implications for the global economy. As the fall in commodity prices is structural rather than cyclical, the outlook for the ‘commodities republics’ for 2016 and 2017 can appropriately be described as "retooling and re-schooling": resources must be shifted out of the extractive industries and labor must be retrained for employment in other tradable industries. This requires reform and restructuring - another headwind to global growth.

Global Policy Response

The silver lining of the sell-off in the financial markets is that it has brought the developed economies’ central banks firmly into play. Mario Draghi chose his words carefully when he said the European Central Bank (ECB) would "review and possibly reconsider" its monetary policy stance. The market, however, took it as a promise of a 10bps cut in the deposit rate in March. My sense is that the market has been thrown off track by Draghi’s muted communication: muted communication is a function of an agreement on the Governing Council that Draghi is not allowed to whip the markets into a frenzy as this puts the Governing council under pressure. I think that the ECB, driven by combination of weak markets, weak growth and low inflation, will over-deliver in March. Back to the good old days…

Although the Federal Open Market Committee (FOMC) followed with a somewhat dovish statement that emphasized the downside risk to inflation, I found it to be somewhat disappointing as it did not take the scope for a March interest rate rise completely off the table. I expect that in coming months we will see speeches from members of the FOMC to indicate that the earliest possible date for the next rate hike is June or maybe even September (admittedly, the latter will be difficult for the FOMC speakers given that the FOMC is in “data dependent” mode). My best guess that the next rate increase will not happen before September.

During the press conference to announce the Bank of Japan’s (BoJ) surprise -10bps cut to the deposit rate, Governor Kuroda drew attention to the fact that Northern European countries had implemented much more negative deposit rates thereby suggesting that more might be in the offing. One wrinkle in the BoJ interest rate cut is that the BoJ introduced a tiered deposit structure which gives the BoJ the flexibility to exempt the banks from incurring the negative interest rate. One week after the eventful BoJ meeting, local media reported that the BoJ would apply the negative interest rate to…well, nothing.

Unsurprising to everyone not on the BoJ board, this was a disappointment to the market. The yen is now back to where it was immediately before the meeting. One problem for the BoJ is that a negative interest rate hurt the commercial banks earnings; obviously, this is not popular. Looking ahead, my best guess is that Kuroda et al. will take another run at applying the negative interest rate to something meaningful and observe if/how this affects the banks’ behavior and the level of the yen.

Altogether, although the format was slightly different than expected, the G3 central banks predictably rode to the rescue as financial market volatility started to take a toll on the real economy. I expect this to continue over the coming month or so.

Global Growth Outlook

With respect to growth, I continue to hold a below consensus outlook for the world in 2016. As noted previously, the world is very unbalanced: as emerging markets deleverage and rebalance, they simultaneously increase their external surplus (ie, they save). The US and Europe have been deleveraging since 2008; now emerging markets are deleveraging. Emerging markets account for 50% of global capital accumulation and 40% of global GDP (source: IMF).

Do we really think that deleveraging in emerging markets will create a very different environment relative to the one we have been living in since 2009? I don’t. What is the scope for the US or Europe to take the other side and re-leverage? The tightening of financial conditions in the US is not conducive to the creation of spendthrift Americans. In Europe, credit creation is held back by a financial system that is either unwilling or unable to extend credit. In the case of the banks of Southern Europe, where balance sheets are clogged by swathes of non-performing loans (NPLs), ‘unable’ applies.

In Northern Europe, fear of hyper-inflation and credit bubbles keeps credit creation in check. The soggy growth outlook is reaffirmed by a downbeat message from our proprietary leading indicators. The bottom line? We continue to live in a world of deleveraging. The good news is that we know this world very well because we have been living in it for the past seven years; the bad news we have been deleveraging for seven years and it is much more fun to spend.

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