August 27, 2015    8 minute read

The Economic Power of China

   August 27, 2015    8 minute read

The Economic Power of China

China’s devaluation may be seen as a distress signal from the country policymakers, which the world’s second-largest economy may be weaker than the 7% a year growth that official figures shown. China has been trying to shift from export-led growth to an expansion based on consumer spending in order to deflate property bubbles. However, the devaluation in turn loosened the yuan’s link to the value of the dollar might prove that policymakers are losing patience with the strategy and reaching for the familiar prop of a cheap currency.

If the economy is indeed weaker than the official statistics, companies that are hoping to export to China in order to reduce reliance on the stodgy European economies should be aware of the risk. The devaluation also pressures other central banks around the world to depreciate their own currencies to help their own exporters and to prevent destabilizing capital flows. But this could affect commodities markets because it signals potential weak demand from China. Furthermore, it could accelerate capital outflows out of China if investors expect further devaluations in the coming months.

Statistics of the devaluation

The FTSE 100 hit its lowest level this year after rumours of a weakening Chinese economy influenced global investors’ confidence. Britain’s leading share index had dropped 1.5% to 6,081.30 by 26th August morning, with Wall Street opening lower as the Dow Jones industrial average fell 204.91 points, or 1.29%, to 15,666.44. The slide on both sides of the Atlantic indicated stock markets across Asia-Pacific markets early on Friday after they went into “panic mode” due to obvious signs of a slowing down Chinese economy affected. This chain-reaction did not only happen to major markets in America and Europe, but also caused a severe damage to emerging markets especially in South East Asia. For example, the ringgit depreciated 1.7% to 4.2838 a dollar as of 8:47 a.m. in Kuala Lumpur by Bloomberg. It reached 4.2990, the lowest since July 1998 and has reduced more than 18% in 2015.

Why the yuan needs to be devalued?

The Yuan’s devaluation was being viewed as China is opening up its financial system and allowing foreign exchange markets have more control over the value of the currency. Also, a weaker currency helps China’s exporters sell their goods abroad. But the devaluation was greeted angrily in Washington. New York senator Chuck Schumer stated that China has rigged the rules and played games with its currency for years, leaving American workers out to dry. Instead of changing their ways, the Chinese government seems to be doubling down.

Republican senator and former US trade representative Rob Portman accused China of trying to gain an unfair trade advantage over America though currency manipulation. If Beijing allows the Yuan to drop further, it could lead to trade tensions and currency war. For now, 4% devaluation in the yuan had caused a massive financial crisis in many countries; but policymakers will be weighing up its consequences in long-term.

Causes of the crisis

The Communist Party’s found it difficult to liberalise markets while still maintaining political control is vital to the recent economy downturn because China represents 15% of the global economy. China is home to low cost manufacturing facilities for U.S. companies whereas the country’s emerging middle class is the fastest-growing market for U.S. products. After the Shanghai Stock Exchange decreased 8.5% on Monday and another 8% on the following day, eliminating the year’s gains, the government reduced interest rates and loosened lending rules so banks can give out cheaper loans.

According to Bloomberg, the People’s Bank of China intended to inject cash into the economy after trillions of dollars in capital evaporated in the market sell-off and the recent devaluation of the currency. In short, the Chinese government has proved the difficulties it faces in dealing with overbuilt infrastructure, excess manufacturing capacity and huge debt in this summer.

There are many reasons behind the slowing down China’s economy. One of the main issues is China’s factory sector dwindled at its sharpest rate in more than six years in August as domestic and exports demand dropped dramatically causing worries that the world’s second-largest economy may be reducing sharply and resulting financial markets into a tailspin. Besides, devaluation of yuan and intense selling in its stock markets in recent weeks has sparked fears.

Shanghai -8.5% (black), Japan -4.6% (yellow), Europe -5.6% (red), USA -3.9%(blue) (Source: NY Times)

Also, countries whose economic fortunes are closely linked to China’s growth tumbled. For instance, Japan’s Nikkei average dropped almost 3% to six-week lows on Friday, while the Kopsi index in South Korea fell 1.92%. Moreover, the long-awaited interest rate rise by the US Federal Reserve was now looking much unlikely according to many financial analysts. Commodities prices are not the exception because of this financial crisis. US crude hit fresh six-and-a-half year lows at $39 a barrel as it headed for its eighth straight weekly decline, the longest weekly losing streak since 1986. Based on Angus Nicholson at IG Markets in Sydney, global markets are in panic mode as the full scale of China’s slowdown becomes clearer.

Overvalued market

Analysts had warned the exponentially rise in China’s stock markets was driven by momentum instead of fundamentals. Stocks were looking wildly overvalued at a time when the Chinese economy was losing steam. Shares in China had raised 150% in the 12 months to mid-June as individual investors piled into the rising market, often raising fund by borrowing. Majority individual investors borrow from a broker to purchase securities and there has been an explosion in margin lending. The broker can make a demand for more cash or other collateral if the price of the securities has decreased, which known as a margin call. However, regulators have cracked down on margin trading in recent months and the resulting falling share prices have caused margin calls. If margin calls continue, investors will be forced to sell other assets to liquidate with the cash they need. There are warnings that majority shares were overvalued and the signs of an economic slowdown were appeared. As fears grew that the rise in many stocks was unsustainable, the selling started.

Intervention of China’s government

There are many rescue plans being carried out recently. For example, China’s state-backed margin finance company, the China Securities Finance Corporation (CSFC), which has a direct line of liquidity from the central bank, has arranged a curb on new share issues and enlisted brokerages and fund managers to purchase huge amounts of shares. Besides, the People’s Bank of China stated that it would continue to work with the CSFC to steady the stock market.

The CSFC also said it would buy more shares of small and medium-size listed companies, which believed suffered the biggest losses in the rout. Mark Williams, the consultancy Capital Economics stated that China’s leadership has doubled down on its efforts to prop up equity prices, because it believes that its own credibility is now coupled to continued gains on the markets. However, the government is aware that deepening losses risk denting the real economy and even fuelling social unrest because majority investors in the market are individuals.

Interest rate rise

Central bankers in the US and the UK have been suggested for months that they are preparing to start increasing interest rates and reversing the emergency cuts made in the global credit crunch with growth strengthening. Mark Carney, the Bank of England governor stated that “the turn of the year” might be the moment to consider tightening monetary policy such as increasing rates. However, the cheaper yuan reduce the price of imports. As a result, this will undermine inflation, which is already at zero in the UK and might delay interest rate rise. A renewed bout of market turbulence as global investors assess the implications of China’s decision could have the same effect based on The Guardian.

Anyone who questioned the importance of China’s economic health to the world has learned an important lesson in globalisation this month. The weakening in China’s economy has caused shocks on stock, commodity and foreign exchange markets in America even there are lower unemployment rates, rising home prices and low inflation in the USA. This is due to China’s slower economy and therefore reduces oil demand, which believed is a main reason for layoffs in Houston.

Furthermore, the latest evidence of Chinese influence happened when a small drop on Shanghai’s tiny stock market triggered a huge fall in New York, the world’s most important exchanges. People believe that the direction of stock prices has become a metaphor for the Chinese government’s fight to prop up the economy against weakness in the country’s export, real estate and debt markets due to limited amount of reliable information.

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