Over the past 150 years, the global economy has been shaped to reflect changes in demographics, political ideologies and economic systems. Some believe the markets can and should be tamed, while others feel the exact reverse.
The Global Extremes
The global payment system, in theory, should balance. There are those who save more than they invest and those who invest more than they save. The former are nations like China and Germany who export around the world, which in turn allows them to run up large cash piles, or savings. The UK and the US on the other hand, over the years, have racked up large deficits, which means such gaping holes in the public finances are plugged by overseas donations.
In part due to economic development and the depth of their respective capital markets, the UK and the US can run these sizeable trade deficits while simultaneously attracting much-needed investment. Few countries have that privilege, yet the UK has put that in jeopardy in opting to leave the single market.
University economics teaches that the equilibrium rate of interest clears the market for savings and investment. When the price of money is in equilibrium, r*, borrowers are incentivised to invest, and savers are given the incentive to deposit money in their accounts.
The bank is the credit intermediary, or to put it in another way, the ‘ringmaster of risk’, who seeks to take short-term funding and lend out for the long term. Such a system relies on trust, or alchemy, as Lord King so eloquently described.
Interest Rates And China
Global rates have fallen as the decades have past due to those with mass surpluses needing a home for their excess reserves. As a result, China owns a good chunk of the US Treasury market, which begs the question of how the Chinese will react when the Federal Reserve begins its tightening cycle in a significant manner, i.e. not simply 0.25% every 12 months.
The Chinese response will likely be to widen the trading band further, depreciating the yuan in order to avoid this ‘hard landing’ everyone is talking about. China is transitioning away from its export model to a service based economy. This will have radical implications for global interest rates. Presumably, as China seeks to export less, this surplus should decline.
Who will supply the rest of the world with cheap goods and more importantly in some respects, who will be the buyer of the US Treasury to keep a lid on borrowing costs?
The Unlikely Scenarios
A scenario where China is running a deficit is about as unthinkable as the UK leaving the EU, maybe more so. The implications though are far more widespread than people think. In such an environment, global rates would rise, and the US might have to think twice about their $17trn debt.
The Chinese might opt for a freely floating currency as the dollar gets stronger, to maximise their export competitiveness and compete with an ever-weakening yen. This would also create deflationary pressures on most nations’ domestic goods, in the hope to persuade home buying rather than buying overseas.
A devaluation of the yuan when the economy is running a surplus would be highly political. That is exactly what happened in the summer of 2015 where markets took the idea of a weaker currency as being a cushion for slower GDP growth.
With a much lower surplus or even a small deficit, it would be distinctly easier to get a weaker yuan, particularly in the political arena, where in many ways, the economics would stack up rather than a ‘beggar thy neighbour’ type of regime.
The Outlook For 2017
If the data points in the US continue to get stronger, the Chinese balance of payments and the exchange rate are definitely the two biggest factors to watch in 2017. The implications for global trade would be immense and the years of QE to achieve inflation may just fly out of the window.