by Andrew Hunt
Despite seemingly a multitude of worries over the potential for a slowdown in US growth, the growing signs of weakness in Japan, the arrival of an industrial recession in Europe and the uncertainty over BREXIT, financial markets have arguably performed remarkably well over recent months. We would argue that the primary positive driver of financial markets over the last few months has been events within China.
Although China’s economy is clearly weak in growth terms – as commodity producers, German car and capital goods producers, Japanese exporters and of course the New Zealand dairy sector can each testify – the fact remains that the desire on the part of Chinese private sector to diversify into non-RMB denominated assets such as property in North America, Australasia and increasingly Europe, bank deposits (chiefly in the US), hoarding commodities, and even direct investments into companies abroad has resulted in what we estimate to be perhaps as much as a US$200 billion per month flow of capital into financial markets.
This rate of outflow, while clearly causing China’s authorities a degree of angst, is probably more powerful than any Western QE type flow. In reality, much of the money that is supposedly being created by the BoJ and ECB QE programmes is not making it ‘out’ of the domestic banking systems – many of the bonds purchases by these central banks are acquired from commercial banks who are then simply sitting on the money by holding them as excess reserves – but China’s outflows constitute ‘real money’ in the hands of ‘real people’ who are spending that money on assets around the world. Moreover, inasmuch as many of these outflows are themselves being funded and encouraged by China’s still very strong state-sponsored domestic credit boom, we have taken to calling China’s outflows as representing “QE on speed”.
However, it is far from clear that China can continue along this track for too much longer. By our calculations, the capital outflows from China are exceeding the country’s trade surplus by two to three times with the result that we believe that China’s underlying Foreign Exchange Reserves position is deteriorating by over a US$100 billion per month. It is estimated by some that if this rate of decline in the FX reserves continues unabated, China will in effect run out of liquid reserves that it can draw upon in the middle of 2017. We would, however, argue that it would make little sense for China to exhaust all of its reserves and to then be obliged to act from a ‘position of weakness’ as much of Asia was ultimately obliged to do in 1997-98. Instead, it would be much more rational for China to seek to act from perhaps a stronger position sooner rather than later.
If China is to staunch its capital outflows, it faces essentially three policy options. China’s first option would be to follow an ‘IMF-style’ adjustment process under which it would seek to improve its balance of payments position by tightening domestic policy settings, raising interest rates and undergoing a significant recession. Such a course of action would clearly be bad news for global growth and certainly damaging to China’s hugely indebted economy and for this reason we very much doubt that this option is remotely practicable. The second option would simply be for China to allow its nominal exchange rate to fall sharply so that foreign assets became prohibitively expensive for its savers and this would choke off the capital flight while at the same time probably providing some form of limited boost to the currently compromised competitiveness of Chinese companies. China’s final option would be simply to ban capital outflows via the use of aggressive capital controls.
We would argue that whichever of the last two routes China ultimately adopts, the result by definition will be less capital outflows from China and hence less support for financial markets worldwide and hence market participants must remain focussed on what China is doing – and when it does it. However, China’s decision will also affect many real world variables within the global economy and in particular we believe that it will determine whether the US (and UK for that matter) experience inflation or deflation in 2017. Clearly, China’s decision will have immense implications for global interest rate trends.
We have long found it helpful to consider the all-important consumer price index of any country to be the result of the (weighted) average of inflation rates in the non-traded goods and service sectors, and the inflation rate in the traded goods sectors. The relative weightings of these two subsets of the index range between around 25% goods, 75% series in the US to closer to fifty-fifty in more open and smaller economies such as Australia and New Zealand. At present, we believe that the service sectors of the US, UK, Australia and some other countries are showing clear signs of resurgent inflationary pressures. Indeed, within the US, we believe that given the still modestly above trend level of demand pressure within the economy, service sector inflation rates will continue to inch higher and that in the near term it may start to approach a four percent rate. This rate of service sector inflation on its own should add about 250-300 basis points to the headline consumer price index level.
However, if goods prices were to continue to decline at their current rates, they will subtract 100-150 basis points from the index level, thereby leaving the headline rate of inflation in the non-oil CPI somewhere around the 1.5% rate over the medium term. Such a rate of headline inflation would probably be broadly acceptable to both the financial markets and importantly the Federal Reserve, who would then be able to leave monetary policy ‘on hold’.
However, we must also be aware that if goods prices were merely to stop falling, then headline inflation could jump to a rate above the FRB’s target. If goods price deflation intensifies for external reasons, then inflation could drop below the FRB’s target even as service sector inflation trends drifted higher.
If inflation rates were to fall further, then they would not only squeeze profit rates further across the world but they would also likely give further impetus to bond prices to move higher, not least of all because lower inflation rates might encourage yet more interest rate and financial repression by central banks. Conversely, if inflation rates were to start rising on the back of stable or worse still rebounding goods prices, we suspect that there would be little below the current level of bond prices except ‘gravity’. Particularly in the cases in which bonds are in negative yield to maturity territory, any upward inflation surprises could cause a marked outflow from what have become notably illiquid bond markets (as a by-product of the changing regulatory environment). Indeed, we believe that any adverse inflation surprise might well have 1994-like implications – or worse – for bonds and it would certainly finish the job of “euthanising” the rentier / bondholder, who has already been punished with low yields for years and who might then suffer a marked destruction of their capital.
With this in mind, we would argue – most strongly – that given the usually slow evolution of service sector pricing trends, it has been goods prices that have generally caused the ‘inflation surprises that have mattered’ over recent years and that over the last 20 years or so as the supply of traded goods has become increasingly globalised, goods price surprises have tended not to come from within Western countries but rather from outside and in particular from abroad.
For example, we remain convinced that the albeit partial recovery in Asian export prices in late 1999 / early 2000 was instrumental in obliging the FOMC to call a halt to the NASDAQ bubble, while the EM’s exporting of deflation of 2002-3 certainly impacted policy in the West. More pointedly, the generally unexpected – or at least under-appreciated at the time – rise in Chinese and Asian export prices that occurred in 2007Q2 led us to finally look towards the end to the Great Credit Boom that preceded the GFC. To this day, we believe that it was the largely unexpected rise in bond yields, coupled with the growing levels of defaults that finally led the investment banks to turn against the mortgage market – the mortgage markets were plainly massively over extended but we suspect that the catalyst for the unwind came from an ‘imported inflation surprise’. Therefore, we believe that what happens next to China’s export prices in USD terms is about to assume massive importance. We also suspect that the rise in import prices was a contributing factor to the decision to suspend QE2 as headline inflation accelerated in late 2011 as import prices rose.
Clearly, if China were to choose to stem its capital outflows through the devaluation route, it would provide a deflationary shock to world trade prices and, given the analysis above, this would represent a bond-friendly, profit unfriendly shock to the global system. However, we also believe that if China were to defend its currency through capital controls, the result might be inflationary for the global economy.
We would argue that one thing that is abundantly clear within China is that compared to any international norms or standards, China’s existing stock of liquidity is 2-3 times as large as perhaps it should be given the economy’s size and that it has been this glut of money-like instruments that has led China’s savers to seek to diversify into domestic property, some commodities and of course overseas assets. However, even if these diversification flows staunch the outflows it would do nothing to solve the problem of China’s now huge monetary overhang. Rather worryingly, history in Eastern Europe and elsewhere suggest that when a currency (and in particular one with a large monetary overhang becomes no longer convertible into foreign currencies, the internal domestic demand for that money will tend to fall and at that point people will try to convert the currency into other usually physical domestic assets such as property, precious metals and often simply goods. At this point, domestic inflation rates can rise significantly within 18 months, as the CEE economies discovered to their immense costs in the late 1970s / early 1980s when their transition policies failed. Therefore, if China were to stabilise its FX rate over the coming few years by in effect suspending the RMB’s external convertibility, we would expect that the population would merely attempt to convert their excess RMB into domestic property, precious metals and presumably basic goods with the result that inflation rates would likely rise in China. However, if China’s price level were to rise while the RMB were held stable, we would assume that this would result in a higher level of export prices from China and therefore a sharply increased probability of a global inflation scare in 2017 that would likely be highly detrimental to bond prices and other asset valuations. Moreover, we should also note that effective capital controls in China would by definition choke off the US$200 billion per month outflow of capital from China into global asset markets that we have described previously.
In conclusion, we suspect that if China were to impose capital controls and then experience faster domestic inflation as a consequence, as we believe it would, it would lead to higher world trade prices (perhaps good news for manufacturers in the short term) but it would ultimately be extremely damaging to the world’s interest rate sensitive sectors such as most financial markets, property markets and even some service sector entities. However, if China allows the RMB to decline, we would expect more global deflation that would eventually lead to some form of fiscal / helicopter money type reaction from Western policymakers. Given these possible scenarios, we are minded to believe that the current ’Phoney War’ over the RMB is simply a calm before some form of storm that will either be inflationary or deflationary depending upon the fate of the RMB.
Andrew Hunt
International Economist, London
Andrew Hunt International Economist London
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