The reaction of developed stock markets to the Chinese shock tells us the long bull run is a bubble overdue to burst
The previous fortnight has been a vintage one. China’s reputation as a growth engine has been put in doubt. The world no longer believes, as it used to, that Chinese policy makers were clever. China will now be treated like any other economy subject to the same laws as the rest. Its growth statistics will be critically examined. Its debt numbers will not be dismissed as easy to handle. China is now normal.
But at the same time, its problems arose at the moment when real status was about to be thrust upon it. The renminbi (RMB) is being considered for reserve currency status by the IMF for inclusion in the Special Drawing Rights (SDR). China devalued, on the advice of the IMF, to show the world that it was a grown up country which could manage a floating currency. Unfortunately, it botched up the communication of the same and panicked the markets. It also did an amateurish and expensive job of handling a stock market crash. Then followed data on slowdown of Chinese economic activity, and the world got spooked.
It may be that the Chinese economy will return to a more peaceful state. It has to transit from an export-driven economy to one based on domestic demand. This transition will take time and one can only hope it will be trouble-free. But there is a ‘black swan’ possibility which we have to bear in mind. China was following the Asia model in its growth strategy. This model was pioneered by Japan. Encourage people to save but pay them a low interest rate by denying them access to foreign capital markets. Transfer the savings as credit for entrepreneurs who would export. The resulting growth momentum was a remedy for Japan for about thirty years, from the early-1960s to the early-1990s. China also chalked up a similar model of growth. Since the early-1990s though, Japan has stagnated. It tried to switch to an open capital market and Japanese firms tried to buy American companies. The attempt was a failure and Japan has stagnated since. South Korea used the same model but has escaped stagnation.
It would be interesting to see if China goes the Japanese way and stagnates or the the South Korean way and manages a successful transition.
The other, somewhat wilder black-swan event is the likely political fallout of the shock. The Communist Party retains its power by a show of omnipotence. To be shown as incompetent and floundering, as with the Tianjin accident and the stock market crash, may lead to political unrest. China periodically has convulsions which last ten years or more—Taiping and Boxer rebellions, the Cultural Revolution. It may happen again.
But the puzzle was the reaction of developed stock markets to the Chinese shock. There was little reason for the fall.
It told us that the long bull run is being seen by many as a bubble overdue to burst. There is nervousness about the large sums of money spent on M&A activities. There is worry about even the mildest tightening of interest rates by central banks.
(Nota bene: I support a twenty-five basis points rise by Janet Yellen at the Fed.) The markets know that sooner or later, all the money dumped on to them by the QE programmes will have to be brought back in by fashioning a smart exit strategy. No one even wants to talk about how that will be done.
The global economy is in its downward phase of a long Kondratieff cycle. Developed economies will have low GDP growth and low inflation for the next ten to fifteen years. Even the BRICS, India excepted, have slowed down. Countries in sub-Saharan Africa, which were beginning to grow at respectable rates, have reacted negatively to the Chinese slowdown. Short of a Schumpetarian clutch of innovations arriving soon, the prospect for the world economy is gloomy.
It is in such a low growth/ low inflation climate that volatility will increase in stock markets. Money is still plentiful. Returns at the fundamental level are low. The search for higher yields will drive investors to riskier choices. The rest will try to rely on false optimism. These two elements spell higher volatility. Equity markets also impose a short-termism on the managers since each quarter they have to show positive results.
Search for higher yields may make private equity firms much more attractive to investors such as pension funds and sovereign wealth funds since they do not face short-term pressures and these investors are also in for the long run. It may even be that as we may be in a downward phase for a long time, investors will switch from publicly quoted equity firms to those where private equity operates. Capitalism lives by constant innovation and the euthanasia of stock markets may be the cure for volatility.
The author is a prominent economist and Labour peer