Analysis

The great British economic rollercoaster (and how to derail it)

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Source: Credit Suisse & Business Insider

The two main challenges facing the UK economy at the start of 2017 are the much trumped-up uncertainties of Brexit and the imminent interest-rate divergence across the rich world. The intricacies and complexities of the Brexit process have the potential to upend quite a few givens in the well-oiled machine of the British economy and create many uncertainties as to the role of the United Kingdom in the wider European and world economies. The main talking points have been waning investor confidence, threatened export potential (somewhat alleviated by the commitment of behemoths Nissan and Google to expanding their activities in the UK), and the value of the British pound.

Bank angles and centrifugal forces

A dilemma that the Bank of England, which has been a favourite punching bag for populists and political opportunists of all kinds and political spectra might have to face in the coming months is whether to increase its base interest rate to defend the pound and prevent inflation at the price of pushing the economy towards recession, or to keep rates low and let inflation run its course and even cross the hallowed 2% per annum.  For now, the indications given by Mark Carney is that the Bank is not ready to endanger the carefully nurtured recovery of the British economy in the name pushing down inflation, whose stubborn bottom-scratching has been the main source of headaches for central bankers in the past decade.

Whilst China was considered the main risk for the world economy at the beginning of 2016, as its slowing economy and bubbly property markets were causing concerns of an imminent meltdown, investors have largely been assuaged that the Chinese government still has the capacity and the willingness to defend the status quo. Major risks have thus shifted from emerging markets to the big Trumpian and Brexitarian question marks in the West. The dangers lingering in the background are the French, German, and Italian elections looming in 2017, which in a worst-case scenario can see Italy and France staging a referendum to leave the Eurozone, which could spell its collapse, with tectonic consequences for European economies. They, just like Britain, will find out that tying the knot is much easier than untying it.

The rich are getting richer and the rich are getting poorer

The second main challenge is related to the divergence in the recovery dynamics of rich-world economies in the aftermath of the Great Recession. The US economy, thanks in part to the decisive actions of the Obama administration and the monetary weight-lifting of the Federal Reserve, has performed well, created jobs, and exhibited rude growth rates in the interval of 2% to 3% per annum. This has warranted the recent decision of the Federal Reserve to restart the gradual process of monetary tightening, begun at the end of 2015 but delayed by perceived market turmoil.  Whilst the UK had for some time been exhibiting similar robustness, Brexit has the potential to jeopardise that and lay bare structural weaknesses such as the abysmal growth of productivity in recent years and high private-sector indebtedness. The Eurozone and Japan, the traditional anaemic patients, have forced their central banks to stay the course of low-interest rates and experiment with unprecedented instruments designed to lift demand out of its almost chronic torpor.

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Source: The Brookings Institute

This divergence in recovery trends might cause instability in the global financial system as the dollar strengthens against other currencies despite the substantial current account deficit of the US. In those conditions, the role of the Bank of England, the European Central Bank, and the Bank of Japan might be constrained by the requirement to protect their ward economies against inflation without knocking out the still fragile patient into a new recession. The compromise between preventing another slump and keeping prices at bay will be finer than ever.

The economics of the European migrant crisis

In 1965, an American economist going by the name of Mancur Olson Jr. published a book titled “The Logic of Collective Action: Public Goods and the Theory of Groups“. Within it, he developed an iconic theory within the field of public choice economics relating to the “logic of collective action”.

His main thesis? He argued that in large groups, the incentive for collective action is reduced dramatically. This was mainly due to the difficulty in organising collective action amongst the members of large groups, which raised the costs of doing so and also due to the fact that the benefit per capita from the collective action would be spread more thinly between large groups. As such, he argued that it would be difficult for large groups to advance their collective interests.

In this light, we can draw similar parallels to the ongoing migrant crisis. With 28 member states, it is fair to say that the EU can be classed as a large group and in response to the growing humanitarian crisis in Syria as well as the surrounding countries, there is a widely held belief that the EU should fulfil its “moral duty” and do its part to help the migrants.

It is here that we can draw upon the arguments of Mr Olson; his key insight was that in many situations, public policy could be classed as a public good, which means that individuals can neither be excluded from benefiting from it nor does consumption of it reduce its availability for others. Based on textbook economics, this naturally leads to a free-rider problem whereby individuals can benefit from the public good without contributing towards it. Recent comments by Hungary’s prime minister Viktor Orban, claiming that this is “a German problem” as opposed to a European problem, are indicative of beliefs that Germany should bear the bulk of the migrants and let the other European countries free-ride off of this solution.

Angela Merkel Urges Europe to Move on Migrant Crisis

However, it is obvious that Germany cannot do it all alone. Indeed, as this realisation has sunk in and as the migrant crisis continues to escalate (with flashpoints such as the distressing pictures of a dead Syrian toddler washed up on a Turkish beach and the stand-off at the Hungarian train station), it has become apparent that the urgency to act has reached a critical level. So much so that the incentive for collective action has been enough to push the European leaders together to come up with a solution. We can only hope that this comes soon enough.

Analysis: The tale of the Chinese stock market tumble

Whilst China’s slowdown no doubt has important implications for the health of the global economy, the events surrounding its stock market crash have proven to be arguably more exciting as in a dramatic reversal of fortunes, the value of stocks on the Shanghai Composite Index collapsed within a matter of months.

Forever rising?

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Having enjoyed a surge in the past year, the Chinese stock market was at its peak in June this year, up 152%  on the year before. However, on the 15th June 2015, the index saw a very sharp and sudden decline in its value, down 2% from the Friday prior. This was just the beginning of a tumultuous decline as the graph below shows and with the exceptions of a few days in which the index rose, there was a complete collapse in the value in the stock market in the days to follow.

All in all, between June 12th and July 8th, China’s main stock market had lost 32% of its value, implying a near $4 trillion loss in the value of Chinese equities. Worse still, symbolising the loss of faith in market forces, many firms listed on the stock exchange suspended trading of their shares with just 3% of Chinese stocks being traded normally at one point.

With the government growing increasingly desperate to restore stability to the stock market, the authorities unleashed a set of measures that were, by all accounts, heavy-handed. They prevented investors holding a stake of more than 5% in a company from selling it. They suspended initial public offerings. Most significantly of all, by using their control over the central bank, they effectively bankrolled the purchase of stocks, by injecting capital into a state-owned ‘margin finance company’ that would lend money to brokerages who had previously pledged to buy up equities.

Nonetheless, it was most likely down to these measures that a sense of calm, albeit fragile, was restored to the markets on July 9th, when the index closed up just under 6%. However, although this respite lasted a few weeks, it unfortunately did not represent a permanent return to the bull market.

The nightmare continues

The next major episode came on July 27th, when the Shanghai Composite Index lost 8.5% of its value in what was the largest one-day loss since 2007. This was likely sparked by a combination of more data regarding China’s deteriorating economic performance and a return to a more bearish sentiment following a few weeks of rises.

Then, we finally arrive at August 24th, a day that has been dubbed as “Black Monday” and rightfully so. Reacting primarily to data suggesting that China’s factory activity fell to a six-and-a-half year low in August from the Friday prior, the Chinese stock market rode a wave of pessimism to plummet 8.5% on the day before, thus wiping out all of its gains from 2015. This sense of panic was mirrored worldwide. In the US, at the opening bell, the Dow Jones suffered its largest point loss ever of over 1000 points before finishing down almost 4%. The story was no different in London where the FTSE100 index fell by just under 5%, its largest one-day loss since 2009, with the same pessimism being mirrored in the German and French equity markets.

So is there anything to learn from this debacle? One thing to note is that there is a running theme with China’s economic problems. Just like with China’s growth saga, the story with the stock market begins with the government putting its faith in market forces; in November 2013, the Communist Party declared that the role that market forces would play in allocating resources within the economy would be upgraded from “basic” to “decisive”. Then, when the tides of fortunes turn, despite the government making their best efforts to respond, they are proven ultimately powerless; Black Monday is a clear testament to that.

Given yesterday’s news of yet another large tumble of 7.6% followed by yet another cut in China’s main interest rate, only time will tell whether the pessimism of the markets or government’s attempts at stimulus will win out.

Analysis: Has the Chinese growth engine stalled?

It has been a turbulent summer for China. We had the Tianjin explosions where there was a severe loss of life and a great deal of destruction. We saw tensions brewing over Japan’s allegedly “evasive” and insincere apology to its wartimes victims on the 70th anniversary of V-J Day. You could be forgiven for thinking that these political issues presented the main challenges that the Chinese government were to face this summer; rather, it has been China’s economic issues that have proven the most troublesome, with first news of a severe slowdown in economic growth and later a stock market crash.

In a two-part series, I will seek to provide the background information to these events and explore the link between them, in a clear and concise format. Let us start first with the slowing Chinese growth.

Full steam ahead?

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It was on the 15th of July that the Chinese National Bureau of Statistics issued their press release for the 2nd quarter of 2015, announcing that the Chinese economy had managed to succeed in “moving forward while maintaining stability” with a real GDP growth rate of 7% on a year-on-year basis.

At first glance, this seems impressive; the growth rate beat a median market forecast rate of 6.8%, the growth rate was precisely in-line with the rate that had been targeted by the Chinese government and the growth rate would indubitably make any other developed country envious. What’s not to like? Unfortunately, this simple fact belies the whole story.

Reading between the lines

Firstly, the Chinese economy has in the past seen much faster growth with a rate of almost 10% being averaged during the 2000-2010 decade. In its place, this rate of 7% is being treated as the ‘new normal’ and is now being targeted by the Chinese government, claiming that it in the mean time it must unswervingly push “forward the system reform and institutional innovation”.

Secondly, monetary easing has been used extensively over the course of the past half-year to stimulate the economy. For example, in the period between November 2014 to the end of June 2015, the People’s Bank of China had already cut its lending rates four times such that by late June, the one-year benchmark bank lending rate had been reduced to 4.85%, a record low. What’s more, this was on top of a reduction in the reserve requirement ratio, in a seemingly desperate attempt to ‘help stabilise growth, adjust structures and lower social financing costs’. As such, although the 7% growth rate was above the forecast rate of 6.8%, given the sheer size of the monetary easing, it can be understood why some may find ‘the sluggish response to the stimulus… disappointing’

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Thirdly, are the reported growth statistics a little too good to be true? Can we trust the data provided or is it too likely a fabrication of the Chinese government? It was none other than Li Keqiang, now China’s premier, who in a leaked memo to the US Ambassador in 2007, asserted that local GDP data was “man-made” and therefore unreliable.

In this light, alternative indicators paint a much more pessimistic picture. For example, it was the news that China’s factory activity may have fallen to a six-and-a-half year low in August that sparked yesterday’s stock market tumbles and as the infographic below shows, this is merely one of many disappointing statistics to come out of China recently. As a result, using such data, various consultancy firms have estimated that growth is much slower than the official GDP figures suggest, with Capital Economics suggesting a 5-6% growth rate whereas Fathom have come to an even lower estimate of 3.1%.

Lex China NEW

So what does this mean? To summarise, we know that the Chinese economy is slowing but by what degree? Importantly, how much of the growth is down to manipulated data or monetary easing?

Whatever the answer, the Chinese economy is facing a crisis. Rodney Jones, founder of Wigram Capital, describes the situation perfectly: “After 30 years, China’s old economic model has broken down and actual growth is much weaker than anything we’ve seen before. The problem for China’s leaders is that their menu of possible policy options is more limited than in the past.”