October 5, 2015
When you look around at the world economy, one thing strikes you: America is on its own in terms of having a growing economy. There simply has not been a period in recent history where global growth rates are so divergent. Europe is still gripped by austerity, Japan hasn’t been right for a generation and the Chinese economy is facing a rapid post-boom contraction. Elsewhere, the big commodity-based emerging markets like Brazil, South Africa and Russia are simply derivatives of China, as their wealth is largely a function of China’s demand for their raw materials.
In this article, I will focus mainly on events in China – or at least in countries affected by China.
The first major issue is that the emerging markets, all those countries that were doing fantastically well because of China’s demand for commodities, are faltering. China doesn’t want their stuff anymore and their wealth is based on the Chinese bidding up the price of commodities, which allows dollars to gush into their coffers. Now that this flow of cash has stopped, they are in trouble.
The second issue is the impact of these divergent growth trajectories on currencies. The dollar has been gaining steadily because the Federal Reserve is on the cusp of raising rates and, even though the trajectory of rates is not going to be significantly upwards, the other major countries are pushing their interest rates downwards. All this is driving the dollar upwards and driving the price of commodities downwards, contributing to the financing problems of the large emerging markets.
Falling commodity prices are not merely the result of technical or exchange rate issues. There is a massive overhang of capacity in the world. Since 2008, the Chinese have been investing in almost everything. All these huge machines, factories, buildings, roads and infrastructure have been built and are now idle. This means that if you want to make anything – you can still make it in China. Imagine a large multinational that operates globally and has a factory in China. Where do you think it is going to make stuff if the demand for that stuff increases? Why in China of course!
Multinational companies operate a global supply chain so until all this excess capacity in China is used up, there will be deflationary pressures everywhere.
This has a massive impact on countries, like Australia, which depend on commodities for much of their wealth. When the price of what you produce falls, it means you have to sell much more of this stuff to buy the other stuff you don’t have and want to have. This is called your “terms of trade” in economics. In recent months this has been turning against Australia.
Of course, Australia is important to Ireland because so many of our young people are there.
For the past few years Australia has been China’s quarry. The resource boom that underpinned Australia’s impressive economic performance is now winding down. Sharp falls in the prices of bulk commodities because of the fall-off in Chinese demand – and to a lesser extent agricultural products – have resulted in a rapid reversal in the country’s terms of trade from a remarkable 140-year high. As a result, the growth rates of household incomes, corporate profits and public sector revenues have all moderated; mining investment spending has fallen. The overall share of plant and equipment outlays as a share of GDP has slumped from a peak above 18 per cent of GDP in 2012 to around 15 per cent of GDP today, and it looks set to drop further.
The only thing that is keeping Australia motoring is a massive credit/housing/lending binge reminiscent of Ireland ten years ago. As we know, this can go on for as long as the banks keep lending, thus inflating the bubble further but at some stage it stops and heads into reverse.
However, the real issue in Asia, Australia aside, is currency related. The dollar links China to the US.
For years the Chinese have linked the Yuan to the dollar. As the dollar rose in recent months, it dragged the Chinese currency upwards. This has made the problems in China worse because they can’t export their way out anymore because the country is losing competitiveness, not least because the currency is going the wrong way.
I fully expect that the Chinese will respond to economic decline and financial market carnage with massive credit creation, exactly as it did in 1989 (Tiananmen), 1997 (Asian flu) and 2008 (subprime/Lehman). The Politburo and the Communist Party cannot allow growth to slip again because economic growth is all they have.
Years ago the Communist Party slogan in China shifted from equality for all to prosperity for all, or at least most, so economic growth is essential for the party to remain in power.
As a result of this, like the Fed in 2008, or the ECB in 2014, the Chinese central bank will become the “lender of last resort” and will print money. This will drive the Chinese currency down and is likely to prompt “me too” devaluations all over Asia from Thailand to Malaysia and ultimately to Japan – China’s biggest trading partner in the region.
This will all drive the US currency up further and will have the impact of making US investments outside of the US cheaper. After all, if your cost base is in euro and you book your profits in dollars, a strong dollar means it makes sense to put more of your business abroad.
And this is where we come in.
Ireland is an unusual country because, although we are notionally European, we actually do best when the US is strong and the eurozone is weak. This is because of the huge amount of US investment here. We look hyper competitive to corporate America when the dollar is strong and we look expensive when the euro is strong.
As a result, the turmoil in Asia and China may actually prompt more investment into Ireland because we look cheap to Americans. Sometimes luck comes your way and it could just be our good fortune that problems somewhere very far away precipitate a positive outcome for us.
It’s the bounce of the ball. Sometimes the ball bounces unexpectedly and you lose and sometimes it just bounces right up into your hands and you are over for the try.
Don’t ask too many questions, just take it!