Bear In A China Shop

 

They don’t happen too often (thankfully) but the theatre of ‘Black Monday’ can’t have escaped many in the world……great stuff for our gloom-addicted media.

 

For the uninitiated, the situation may seem head-scratchingly complex and that the world is about to explode. So, with my patronising hat on, here's a bite size guide.

 

DIY Investors

The story of China has been one of extraordinary growth in the last decade but there have been recent concerns that there will be a significant economic slowdown. One worry is that this would trigger panicked reactions from investors and lead to a stock market crash.

 

With China establishing its Shanghai stock exchange only in 1990, its market is considered immature compared to the rest of the world. In addition, the shares are almost entirely owned by domestic traders, many of whom are amateur investors with little experience in investing. The lack of large, experienced and professional organisations as investors means that the market is much more volatile.

 

China Central Bank

Over the last few months, China's central bank has been repeatedly propping up the stock market to ensure stability……it has been buying shares to keep them artificially high instead of allowing the natural effects of elasticity and demand / supply. There has also been a cutting of central bank interest rates, which allows more money to flow easily.

 

After losses last week on the Shanghai stock exchange, there was an expectation that there would be yet another such drastic move. But that did not happen and caused panic to ripple out and a dramatic drop in shares on Monday (worst single day plunge since 2007).

 

Yuan

As I blogged recently, one of the possible triggers for the market drop was the earlier decision by the central bank to devalue the yuan and allow it to trade more flexibly.

 

Unlike most currencies, the Chinese currency is not allowed to trade freely according to the number of buyers and sellers in international markets. Instead, the central bank sets a daily rate to the US dollar and for the rest of the day, the yuan is allowed to trade up / down from that rate. Earlier in August, the bank cut that rate by almost 2%, sending a first wave of insecurity through markets. The move was seen as an attempt to help exports by making Chinese goods cheaper abroad.

 

China Now A Big Deal

What recent events have shown us is how much of a linchpin China's stock market is in the global marketplace. China's market was broadly irrelevant 35 years ago but the simple fact is, they have grown to be the second largest economy in the world and this makes China a far bigger deal these days.

 

Rude Awakening

Monday's global turmoil sparked fears of another international financial meltdown but in general analysts say it was merely over-inflated markets correcting themselves. Time will tell. As for China itself, analysts say that as the market matures over the years and investors become more experienced, it will become less volatile. This could also happen if China's Government removes some of the restrictions that hinder foreign ownership of shares, paving the way for bigger more professional firms to come in and inject stability. Currently foreigners only own 2% of stocks.

 

The reality is, China's economy is still expected to slow which in turn would affect the global economy, particularly Western growth. But many anticipate that China’s Government will continue to prop up the economy (one way or the other!) and even more so in light of this recent financial volatility.

 

It's difficult to see the Government in China allowing the economy to slide further without some countervailing action. History tells us that they tend to be meddlers after all!

China In Your Hands

 

There have been some huge ripples over the past 10 days as China has taken action to make itself appear more sexy to……well, errrrr….itself. And just to clarify, sexy in an economic context (should such a thing exist!).

 

Why the ripples? That’s an interesting one.

 

China devalued its currency against the US $ by 1.9% which is a tiny devaluation in the grand scheme of things. In reality, the devaluation is unlikely to have an immediate effect on exports and it is hardly anywhere near a ‘proper’ devaluation of 20 - 30%.

 

Perhaps the bigger question we should be asking is why now?

 

China has been under international pressure to allow its currency to be driven by market forces (that old chestnut of ‘demand’ and ‘supply’) as opposed to being set by the Governments. The US has been its biggest critic saying that Beijing keeps the currency artificially low to help boost their exports.

 

So in theory, China says it is doing what the US and the international community wants and allow the Yuan's value to be more flexible. This has already got it a nod of approval from the International Monetary Fund (IMF) which overnight said China's new mechanism for setting the daily reference rate for the Yuan was a "welcome step".

 

You see, China wants to enter the IMF's elite global currency club……something it can't do without more of a market driven exchange rate.

 

In theory - the US should have welcomed this move too but the US Treasury said: "We will continue to monitor how these changes are implemented and continue to press China on the pace of its reforms. Any reversal in reforms would be a troubling development."

 

So let's go back to that key question……why did China devalue its currency now and allow for market forces to play more of a role now?

 

Well, some economists say the timing of the depreciation appears to be far too sudden and a kneejerk reaction to their weaker than expected export figures (recent figures showed a slump of more than 8% from last year). Analysts fear that Chinese officials are clearly concerned about the fact that rebalancing their economy and moving from exports to consumption is taking longer than they expected.

 

The reality is that rebalancing takes time - but it appears that it may be taking too long for Chinese officials to allow the economy to re-engineer itself.

 

Whether all of this justifies the ripples the devaluing has caused, is down to opinion. But one thing is for sure, China has ruffled US feathers.

Interesting Interest Rate Impasse (Part II)

 

The U.S. Central Bank (the Federal Reserve or ‘Fed’), is widely expected to increase its headline interest rate this year. There is no doubt that this will have a knock on effect to the UK, which is likely to follow with similar action. This clearly has lasting implications for anyone with a mortgage or bank based savings……that’s a huge slice of the UK affected by US interest rate actions.

 

Put simply (probably patronisingly), Central Banks use interest rates to affect the economy and to control inflation. The US rate is currently set at 0.25% and has remained there for around 7 years. The International Monetary Fund (IMF) believes a US rate rise in early 2016 will be suitable but the Fed is widely expected to increase later this year instead following their September meeting.

 

The interesting thing about interest rates is the impact of a rate change does not come from the rate change itself but rather from market expectations about future rate changes.

 

Since the US rate has been so low for so long any increase at all (however slight) will signal a shift in US monetary policy. The immediate impact is households will have less disposable income and businesses will face increased borrowing costs, which will make some projects appear unfeasible. The medium term impact is both households and businesses could put off some of their spending until they get a clearer idea of how frequently these rate increases will come and what size increases we will see.

 

Some commentators are concerned that financial markets, particularly US shares, could experience a fall as they have been kept buoyant by the low interest rate environment. Another concern is the US economic recovery, which has been strong but is still not booming, may slow down which could cause the US to enter a period of slowing or falling economic growth.

 

Of course all of this is factored in by The Fed. This is why any interest rate rise will only take place when the fundamentals are correct……after all, nobody (particularly US policymakers) wants to see falling share markets and slowing economic growth. Any interest rate change will be designed to support a growing economy while also allowing for the fact that rates simply can’t stay low forever.

 

Interest rates are a very useful policy tool for Central Banks, one they don’t want to do without. If the US was to enter a recession tomorrow (with interest rates at 0.25%) the Fed would have no scope to cut rates in order to stimulate economic growth……it would be like going into a fight with one hand tied behind your back. It logically follows that the faster the Fed can raise rates, the easier it can cut them again in the event of a downturn. The trick is to balance increasing rates without causing a slowdown in key economic indicators such as unemployment and economic growth figures.

 

While no-one expects rates to shoot up, this is likely to signal an end for ultra-low interest rates (for now at least). The longevity of these higher interest rates will depend entirely on the continued strength of the global economic recovery.

 

But remember one thing……when the US sneezes, the UK catches a cold.

Interesting Interest Rate Impasse

 

 

It’s in the news regularly and we can’t ignore its importance to savers, homeowners and businesses……but the current interest rate level is certainly a cause for debate, caution and concern.

 

In the past few weeks, both Janet Yellen (US Federal Reserve) and Mark Carney (Bank of England) have prepared the ground for a rise in interest rates, possibly by the end of the 2015. The age of rock bottom interest rates may finally be drawing to a close……but to be fair it’s been a long time coming.

 

Whilst this may start to wet the lips of savers eagerly looking forward to a return to past levels of interest rates……the excitement could be misplaced.

 

The time may well be right to start raising rates again given that the UK economy is approaching full employment and earnings (including bonuses) are growing at 3.2% per annum. However, both these central bankers have tempered their warnings by suggesting that the tightening interest rate cycle is likely to prove only gradual and exceptionally shallow by past standards.

 

For Mr Carney, the “equilibrium rate of interest” is likely to be about half the level of its pre-crisis average……suggesting a peak of just 2.25%. This can hardly be considered a Christmas come early for long term savers if inflation returns to its 2.0% level. In fact, that’s barely a real rate of interest at all. Unfortunately there are lots of good reasons for thinking much lower interest rates are indeed here to stay, not least another five years of relatively aggressive fiscal tightening.

 

To argue the contrary point of view might seem a stretch, but Mr Carney may be proved wrong. Firstly, policy-makers have a long history of misjudging these things or missing significant turning points until after the event. The Bank of England’s failure to foresee the financial crisis is a case in point. Secondly, rarely do interest rates rise in an orderly fashion to some kind of pre-ordained plateau. What instead tends to happen is that the central bank gets stuck behind the curve and is then in a panic forced to play catch up.

 

Plenty to consider on both sides of the argument but there is one thing for sure……interest rates will rise.

 

It’s just when and by how much that is left to debate!