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Macro View: Chinese devaluation could trigger global crisis

Ambiguous Chinese efforts to calm market only accentuated fears that this is not a one-off, but a precursor of future devaluations

THE shock decision of the Chinese authorities to allow abrupt falls in the yuan was an unpleasant surprise for the financial markets and a most unwelcome development for China’s trading partners.

By acting unilaterally, and in a manner that appears aggressive to other Asian nations, the Chinese risk unleashing a disruptive currency conflict that could damage trade relations and also unsettle the fragile political balance between China and its worried neighbours in east and south-east Asia.

Beggar thy neighbour

The 1.6% annualised fall in Japan’s GDP in the second quarter of 2015 is a stark reminder that other regional economies are also facing pressures. Some of them may see China’s move as part of a dangerous “beggar thy neighbour” strategy. If Japan now intensifies its policy of weakening the yen in order to boost growth, we would be one further step down the slippery slope of a regional currency war.

Apologists of China’s action argue that the scale of the devaluation is modest compared with market-driven moves in currencies such as the Brazilin real or the Turkish lira. They also claim that the sharp trade-weighted rise in the yuan earlier in the year, due to big falls in the euro and the yen against the US dollar, justify the devaluation as a necessary defensive reaction. But the markets are not persuaded by these arguments.

The fact is that the recent move was the biggest fall in the yuan in more than 20 years. More ominously, subsequent Chinese efforts to calm market nerves were ambiguous, and only accentuated fears that this is not a one-off, but a precursor of future devaluations. While China’s move is widely seen as a response to recent falls in exports, it is also the result of deeper problems facing the economy.

There are widespread perceptions that the official statistics exaggerate the ‘true’ growth of the Chinese economy. China’s huge debt burden, which has worsened due to steady falls in wholesale prices, will damage further the country’s ability to expand.

So far, the slowdown in Chinese growth is not unduly alarming. Our current GDP forecasts, 6.8% in 2015 and 6.5% in 2016, are still consistent with a soft landing. But the outlook is becoming increasingly uncertain. There are disturbing signs that labour is weakening and unemployment is rising. This could endanger the country’s social cohesion and could pose potential threats to political stability. Though the authorities are highly sensitive to these risks, they are reluctant so far to boost job creation by unlashing a new wave of bank loans, which could worsen the debt problems and damage the economy in the longer term.

China’s leaders know that the only answer is to persevere with structural reforms. But these take time and are difficult to implement, because they challenge powerful vested interests. Allowing the yuan to fall may well reflect genuine uncertainty and hesitation within the Chinese leadership on the best way forward. China may still draw back from pursuing an aggressive path, because it would mean abandoning its ambitions of enhancing the yuan’s status as a global reserve currency, and entering the elite club of currencies making up the IMF’s SDR (Special Drawing Rights) basket. The next few months will provide the answer to the crucial question whether China’s integration in the world economy will continue or come to halt.

Deceptive calm

The eurozone is now enjoying a deceptive period of calm, as fears of a disorderly Grexit have faded following the €86bn bailout. But, although the deal gives Greece and its creditors precious time, it doesn’t offer Greece adequate debt relief and doesn’t address fundamental issues that triggered the crisis in the first place. In spite of the current sense of relief, it is realistic to expect a new Greek crisis in the next 1-2 years.

Meanwhile, it is worrying that the improvement in the eurozone’s growth prospects, which has been apparent in recent months, is now showing signs of stalling, as real GDP slowed to 0.3% in the second quarter of 2015, down from 0.4% in the first three months of the year and less than expected. France was a big disappointment, as its quarterly growth dropped to zero in the second quarter, from a relatively robust 0.7% in the first quarter. There were some positive features in the GDP report, with healthy growth in Spain and Greece; but the eurozone’s overall performance was disappointing. Weak growth, coupled with relatively high unemployment at 11.1%, and very low annual inflation at 0.2%, will reinforce the ECB’s determination to maintain expansionary policies and complete its €1.1tn (£780bn) QE programme by September 2016. The ECB will not consider any increase in official interest rates until early in 2017.

Pedestrian growth

US economic performance remains mediocre by historical standards. Full-year GDP growth is forecast at 2.3% in 2015, slightly lower than the 2.4% growth in 2014 and also weaker than was generally expected until recently. This middling record is partly due to harsh winter conditions, which resulted in low growth in US output in Q1, and reduced growth in 2015 as a whole. The strength of the US dollar has also been a dampening factor this year.

Nevertheless, growth prospects, both short and medium term, remain better in the US than in the eurozone and Japan. In 2016, we are predicting stronger full-year US growth, at 2.7%. The economy created 215,000 new jobs in July 2015, slightly less than expected, but still satisfactory. The US jobless rate was steady in July, at 5.3%, the lowest rate since the financial crisis.

Though US growth remains pedestrian, it is sufficiently robust to support the view that the Federal Reserve will announce the first increase in official interest rates before the end of 2015. Signs that the US labour market is tightening, coupled with stable core inflation at 1.8%, just slightly below the Fed’s target, reinforce the prospect of an early rate rise. But it is still uncertain whether the Fed’s first move will be in September or December. The turmoil unleashed by the Chinese devaluation and low global growth, signalled by falling oil and commodity prices, indicate on balance that the Fed will wait until the end of the year. Once the US starts tightening, the pressures for a UK increase in rates will intensify.

The UK recovery is still fragile, and there are powerful reasons for postponing a policy tightening until well into 2016. However, recent comments by members of the MPC (Monetary Policy Committee) have given a clear indication that an early rise in rates is increasingly likely. We expect the first UK increase early in 2016, but one cannot rule out an earlier move before the end of 2015.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist

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