posted on 14 November 2015
by Richard Duncan
China's economic model of export-led and investment-driven growth is in crisis. With no one left to export more to every year, China now finds itself with extraordinary excess capacity across every industry. Product prices are falling, companies are unprofitable and bank loans are going bad. Any further investment will just worsen the situation.
Therefore, China is buying much less raw materials from the rest of the world. As a result, commodity prices have collapsed. Last month China's imports were 20% less than during the same month last year. So, China is no longer a driver of global growth.
In fact, it is a very significant brake on global growth.
For that reason, many of the emerging market economies around the world have suffered a very sharp economic slowdown or even gone into recession. Many emerging market currencies have dropped substantially in line with the economic growth prospects of the emerging markets.
As many of these countries have borrowed heavily from abroad in recent years, often borrowing U.S. dollars, there is now a growing chance that they will not be able to repay those loans. Many creditors are attempting to withdraw their money from the emerging markets before the debt defaults begin.
The resulting capital outflows are compounding the problems those countries now face by making credit more expensive. All of these problems combined have thrown the global economy into a new recession that seems likely to become considerably worse before it gets better.
The dollar is the principal international reserve currency for one reason: the United States runs massive trade deficits with the rest of the world every year. That means that the rest of the world accumulates hundreds of billions of dollars every year. These they must invest in U.S. dollar-denominated assets, like U.S. government bonds.
The yuan is not an important international reserve currency because China does not have a massive trade deficit. Instead, it has a massive trade surplus every year. For that reason, other countries don't own a lot of yuan. If China began to run a huge trade deficit with the rest of the world, then other countries would have a lot of yuan and they would be forced to buy yuan-denominated debt instruments.
Then the yuan would be an important reserve currency. But running a large trade deficit would cause tens of millions of Chinese factory worker to lose their jobs, leading to social instability. For this reason, the yuan is unlikely to become an important reserve currency within the foreseeable future - if ever.END Pull Quote Right
China's economy is now under severe strain. Chinese policymakers would like to devalue the yuan against the dollar to boost China's exports and economic growth. But China's trade surplus with the United States was $340 billion last year. That means that, in the absence of intervention by the Chinese central bank, the yuan would appreciate against the dollar, not depreciate.
The value of the yuan relative to the dollar is something that is negotiated between the U.S. and Chinese governments on an ongoing basis. The U.S. government would like the yuan to continue appreciating against the dollar so that China's trade surplus with the U.S. would stop expanding. The U.S. government certainly does not want the yuan to be devalued.
Not only would that further weaken the competitiveness of U.S. exporters relative to Chinese exporters, it would also export deflation to the United States since the U.S. buys $500 billion worth of goods from China every year. Any yuan devaluation would cause the price of those imports to fall and that would cause the U.S. price level to fall.
China, on the other hand, does not want the dollar to strengthen any further relative to the euro and the yen. That's because the yuan is closely tied to the U.S. dollar, so when the dollar strengthens against the euro and the yen, so does the yuan. A stronger yuan hurts Chinese exports to Europe and Japan. Therefore, China does not want the Fed to increase interest rates since higher U.S. interest rates would cause the dollar and the yuan to appreciate against other currencies.
If the Fed does increase U.S. interest rates, China may devalue the yuan vs. the dollar so that the yuan does not appreciate against other currencies. One theory suggests that the small yuan devaluation in August was a warning to the Fed not to hike rates or else China would devalue.
A large devaluation of the yuan would be a terrible blow to the Fed because it would push down U.S. inflation (perhaps into negative territory), making it much more difficult for the Fed to reach its 2% inflation target.
If China does devalue, the rest of the world would suffer. Commodity prices would fall further. Emerging market economies and their currencies would weaken further, increasing the chances of a new EM debt crisis. Corporate profits would be hit and global stock markets would sell off.
I expect the Fed to launch a fourth round of Quantitative Easing to keep the United States from falling back into recession.
Since 2008, credit growth has been too weak to drive economic growth in the United States. So the Fed has been driving economic growth by printing money and pushing up asset prices to create a wealth effect that spurs consumption and economic expansion.
After QE 1 and QE 2 ended, US asset prices fell and the U.S. started to go back into recession. Each time, the Fed launched another round of QE to prevent that from happening. I believe the same pattern will be repeated now that QE 3 has ended. The U.S. economy is already weakening very visibly.
I don't think the Fed will launch QE 4 because it thinks it will be "the right solution for the emerging global economic situation." I think the Fed will launch QE 4 because it is afraid that the U.S. economy will fall back into a very serious recession if it does not.
Having said that, I do believe that QE 4 will benefit emerging market economies in the same way that the first three rounds of Quantitative Easing did.
Another policy option would be for the United States to run a much larger budget deficit to provide fiscal stimulus to the US and global economy. That, however, will not happen before the 2016 U.S. presidential elections at the earliest, and probably not even after the elections.
Another policy option would be to do nothing. That's the option policymakers picked in 1930. The result then was a global great depression. If policymakers choose to do nothing now, there is likely to be another global great depression.
The United States has been the driver of global economic growth since World War II. It is no longer growing enough to continue driving the global economy, but there is no other country that can take its place. In order to take over as a new driver of global growth, a country would have to run an even larger trade deficit than the U.S. does. That won't be possible.
What could Japan have done to accelerate Japanese economic growth in 1990? After the great Japanese bubble economy had taken shape, I really don't think there was anything Japan could have done to accelerate growth there. China is now in the same place Japan was in 1990. There is a huge economic bubble in China. I don't see what they can do to "accelerate economic growth going forward."
They will have a hard enough time just to prevent the bubble from collapsing into a serious depression. It will require very large budget deficits, a great deal of skill and a lot of good luck for China to even achieve 3% annual growth over the next 10 years.
All the government policies since 2008 (trillions of dollars of deficit spending, trillions of dollars of fiat money creation, 0% interest rates, etc.) have prevented a new global great depression thus far.
But now, since the end of QE 3, the policy stimulus is no longer adequate to keep the global bubble inflated. It is now starting to deflate. Our choice now is between more stimulus and a devastating new global depression that could very possibly destroy the world as we know it.
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