As China fire continues to singe, expect uncertainty to rule stocks, currencies

Chinese jitters have caught on with trading coming to a halt on Thursday with the 7% circuit breaker being breached again in the current week. Officially there is a 15 minutes break if shares move by 5% while it gets suspended for a day if it goes past 7%. Given the size of the Chinese economy, being the second largest in the world, and the fact that it has been the guiding force for the movement of the world economy it is not surprising that the world stock markets got spooked sequentially. And judging by the way things are moving, it is unlikely that there will be some sanity any time soon. Just where is the problem?

As China fire continues to singe, expect uncertainty to rule stocks, currencies

The chinks in the armor of China have been exposed in the last year with the realization that an investment based model of growth is not sustainable unless supported by consumption. Large capacities have been built by companies especially in the metals space to support grandiose infra plans. This had sent commodity prices spiraling upwards. But with the slowdown coming through, prices have reversed and the nation has witnessed a significant slowdown leading to excess capacities which in turn had brought fresh investment to a halt. In particular, oil and coal prices have been affected with this sharp downturn in the Chinese economy.

The panic has been even more palpable as retail investors have rushed in to sell and this bearish phase is unlikely to settle soon. There are now expectations that the economy will slow down further. Both the manufacturing and services segments have shown a slowdown, with the latter being the surprise package of late. China is to announce its GDP numbers later this month and until there is clarity on this issue stock markets will continue to tumble.

The panic has been exacerbated by the contagion effect to be felt on US markets. The rout is quite different this time. A large part of the revenue of US companies- estimated to be something close to 40% - comes from China and a major fall in growth rate would have backward links on their prospects. With fears of their earnings being affected the US markets have also quivered and will continue to do so until there is some semblance of equilibrium in China. This has caused the stock markets across the world to tumble with India not being spared despite the fact that ours is still considered to be the fastest growing economy with brighter prospects. Hence in terms of stock markets there has been a contagion effect across all countries.

The central bank has promised to inject more liquidity into the system (which can go up to $10-11 billion) which comes on top of the rate cut announced in 2015. The yuan was devalued and there are expectations that China will continue to let its currency move down as it is an effective way to prop up exports. Such an action will affect all countries as the dollar strengthens.

Two outcomes would result. First, there would be a tendency for there to set in a spate of competitive devaluations by countries to ensure that to the extent there is an export competitive advantage that they should not lose it. This is the typical ‘beggar-my-neighbour’ policy that is pursued under these circumstances. In fact the initial devaluation provoked by China in August 2015 had similar outcomes from other emerging markets.

The second is a conjecture on the reaction of the USA. While growth has been stronger in relative terms, the fact that companies are being affected by the slowing down of export market to China, it would be served a double whammy with the currency also moving against them. The question is as to for how long will USA wait and watch?

Correspondingly, within China it has been observed that there are fresh issues on the employment side with the labour force not increasing commensurately with the demand that is there for skilled labour force. There are two reasons for this. First, the one child policy pursed aggressively has come in the way of basic growth in potential force and second, there has been less emphasis on skill sets. Also the more educated students have preferred to move overseas for further studies and employment. This is another factor that the market sees as coming in the way of future growth of the country.

What are the implications for the world economy? The present panic in China will probably get sorted out as things go back to normal, especially so since the slowdown in China was known earlier and not exactly a new phenomenon. But markets being sensitive do react to such news quite dramatically that causes upheavals across the world given the inter-linkages.

Financial markets will remain uncertain which will be witnessed in both the stock and currency markets. Growth prospects for the global economy can be impacted indirectly if the US gets affected. On the whole it would be more volatility in the short run but definitely a speed breaker for the overall growth process in the medium run.

The writer is a chief economist with CARE Ratings, and his views are personal.

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Updated Date: Jan 07, 2016 13:30:19 IST

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