According to the Chinese Zodiac, 2015 is the Year of the Goat, supposedly a calm, uneventful year. Yet, with the 40% drop in the Chinese stock market, the country’s consumers and investors are anything but calm. The turmoil in the world’s second largest economy has put the entire world on edge. The question is whether the financial panic that began in Shanghai and encompassed global stock markets is real, or just short-term emotional reaction to volatility expected from an emerging equity market.
Plummeting commodities, fragile currencies, burgeoning fiscal deficits, dwindling reserves and eroding credit conditions would suggest the problems are indeed real.
Oil is the commodity on most minds, plummeting from $100 per barrel last year to less than $40 per barrel in 2015. And China’s reduced oil consumption is a major contributor to its price weakness. While historically the fall in prices would trigger a reduction in production, today members of the Organization of the Petroleum Exporting Countries (OPEC) such as Saudi Arabia would rather grab market share at lower prices than trust its partners to work together. More importantly, the drop in oil has caused the Saudis to issue domestic debt for the first time in eight years, while the United Arab Emirates (UAE) will see its consolidated budget run a deficit for the first time in five years. Adding to the pain in the UAE is a non-hydrocarbon sector highly dependent on Chinese capital inflows in the financial, construction, and tourism sectors.
As China slows, it only adds to the pain inflicted by lower oil prices. Moreover, China consumes about half the world’s iron, aluminum, nickel, and steel, and nearly a third of its cotton and rice. The cutback in Chinese consumption has especially hurt Brazil, whose economy was already faltering so badly that Standard & Poor’s recently cut its credit rating to junk status. In the past year, the Brazilian real has fallen from 2.24 Real per dollar to 3.65. This has made it more expensive for Brazilian companies such as Petrobras to pay off their international creditors.
Though current emerging market conditions lack the severity of the 1997-98 crisis, in one aspect today may be more problematic. The weight of emerging markets in global GDP on global growth is now much heavier because of China’s greater mass, as slower growth is more painful to rich countries. World trade suffered its biggest fall since 2009 in the first half of this year.
China’s response to the trading slowdown was to devalue its currency. Also, China wanted to show the IMF that it has a market-led currency that would fit nicely into the IMF’s basket of elite currencies. While the move might have strengthened China’s hand, it weakened emerging markets such as Colombia, Brazil, Indonesia and South Africa, whose export economies depend on China. Foreigners own between 25% and 50% of the stock of emerging market government bonds, and as their currencies fall and their economies falter, those bonds become nearly impossible to repay.
The greatest challenge is that the global slowdown is happening at a time when central banks have few monetary cures to employ. The recovery from the 2008 meltdown has been anemic, at best. Interest rates are at record lows, and central bank balance sheets are full of bond inventory from global quantitative easing. The world’s currency markets have weakened 17% vs. the U.S. dollar in the past year. Should China continue to falter, the impact on global GDP may be dramatic.