Avery Shenfeld is chief economist at CIBC.
Unlike Las Vegas, what happens in Shanghai doesn't stay in Shanghai. Clearly, the jitters that have showed up most dramatically in Chinese equities have spilled over into a global equity correction, and to a heightened concern in both foreign exchange and bond markets over emerging market economies.
What will determine how long, and how deep, the current risk-off run lasts? Keynes is the cure. The market needs to see China become more aggressive on interest rate cuts and fiscal stimulus to gain reassurance that its economic growth will not decelerate further.
The geographic origin across the Pacific, the weakening in global commodity prices and the tumble in emerging market currencies have some drawing analogies to the Asian crisis of 1997-98. But this isn't a replay of that particular slump.
Then, the focal point was initially on Southeast Asian emerging markets (Thailand, Malaysia, Indonesia), those that were running large current account deficits whose currencies were vulnerable to the combination of heavy foreign currency debt and limited FX reserves. It was capital flight that triggered the growth issues. The declines in exchange rates were on the order of more than 50 per cent for those at the centre of the storm. One can hardly say that this crisis was triggered by a 4-per-cent move in the Chinese yuan. Indeed, the capital outflows from emerging markets preceded the yuan adjustment. These other emerging market currencies, while down sharply, aren't seeing a free fall and are better backed by reserves than they were in the late 1990s.
Still, saying this isn't a replay doesn't mean that it's not a crisis of its own variety. In this case, it's not one that originated in currencies (the initial moves were minor), in fears of Federal Reserve hikes (the market never built in that many) or even in the sell-off in Chinese stocks (there have been large corrections in the past that didn't impact real growth). Financial markets are following, not sparking, the trouble.
Instead, the recent flight from risk is rooted in the real economy: Insufficient economic growth in China, amid a global economy that doesn't have enough healthy engines to be blasé about a major engine gearing down. To be sure, the yuan depreciation drew market attention to the Middle Kingdom's fragility. The Shanghai market's refusal to kowtow to futile efforts from Beijing to stem its slide has diminished confidence among global investors in the ability of the leadership to manage the economy. But none of this would have spread, or had any staying power, if not for the underlying fundamental story of a deceleration in Chinese growth that stretched back to early this year and the lack of enough growth elsewhere to maintain resource demand globally.
In part, there is a foreign exchange element to the story – not in the recent Chinese depreciation, but in the longer-term yuan appreciation that preceded it. Letting the currency move was part and parcel of an overall strategy designed to rotate growth away from exports, private and public fixed capital investments and housing towards consumption. What's gone off the rails for China is that consumption growth has been insufficient to fill the gap left elsewhere, and we suspect that GDP growth has run below official data. In addition to our principal components indicator, which has decelerated more sharply than its usual tie to GDP would suggest, the fact that China has turned to renewed stimulus – including reopening the spigot on housing credit – is a signpost of concern in Beijing over underlying growth.
But there is a response that could turn the tide. China has room to cut interest rates or reserve requirements – with inflation below target and the zero bound not yet in play – and room to unleash fiscal stimulus in an economy where governments can act quickly. It could also let the currency ease another 5 per cent to 10 per cent to help exports, but that would be less helpful to global sentiment, since foreign exchange moves are a zero-sum game across countries. Rate cuts and government spending won't create instant good news in the hard data on economic performance, but financial market sentiment globally might be improved if China is seen to be moving more aggressively to reignite economic momentum.
Longer term, the nature of the growth that would create is not ideal. Lower interest rates could feed a renewed housing bubble, while local government or state-owned-enterprise capital spending has, in the past, left much to be desired in terms of the value of the assets generated. But in this case, short-term gain will outweigh longer-term pain. Beijing will have to put aside its longer-term objective of refashioning itself as a consumer society, in the interest of forestalling a hard landing here and now.
A firmer global economy might later allow the government to wind down public sector spending without triggering a too-sharp deceleration in economic performance. And a maturing recovery in Europe, as well as enhanced growth in other emerging markets (India and others) would eventually wean us off reliance on Chinese demand, a necessity given that longer-term trend growth in China is likely to be no better than 5 1/2 per cent.
In the interim, as we wait for China to act more decisively, the global risk-off trade could take the recent correction in equities further, and play into a flight-to-safety bid for less cyclical assets. While there are obvious question marks, don't yet shut the door on a Fed hike in September. If, by then, U.S. stocks have levelled off after a correction, rather than diving into an outright bear market, the central bankers could still proceed to nudge rates higher.
A version of this op-ed was distributed to some CIBC clients late Monday.