China and the US Fed: Leading the World Toward Extreme Volatility?

By Dr. Ivo Pezzuto, Global Markets Strategist, Member of Advisory Boards, Int’l Lecturer and Consultant, Author of the Book “Predictable and Avoidable. Repairing Economic Dislocation and Preventing the Recurrence of Crisis”

The summer of 2015 probably will be remembered in the years to come as one of extreme volatility across global markets. In fact, in the middle of August, a peak of volatility rapidly spread internationally, triggered mainly by a combination of catalysts. These included, first and foremost, the potential decision by the US Federal Reserve to start tightening its monetary policy in September 2015, China’s enduring economic slowdown and the fears of a potential “hard-landing” scenario, and the epic stock market correction that followed China’s central bank’s unexpected decision to devalue its currency on August 11.

This combination of triggering factors has shocked the markets, making them risk averse, thus spurring additional capital outflows from China and emerging markets and sparking volatility to levels unseen since February 2009. The global sell-off, the shock devaluation of the yuan, the collapsing commodity prices, and the deflationary headwinds triggered by a potential Chinese “hard-landing” rattled world markets and sparked exchange-rate declines in emerging economies.

The Shanghai Composite Index tumbled approximately 40 percent in August, since reaching a seven-year high on June 12, erasing $5 trillion in value on mainland bourses, as traders cut leveraged bets. Its sharp correction signalled that it had been clearly overvalued in the previous months (bubble). In fact, in June 2015, the index was over 5,000 points from approximately 3,000 points in December 2014, and in August 2015, it was back at the same level it was in December 2014, after the strong correction.

China’s equity rout has sparked higher volatility (measured by the CBOE Volatility Index-VIX) and the sell-off of global risky assets. After the initial emotional (panic) reaction to the Chinese stock market crash, the declared commitment of the Chinese authorities to stabilize their economy and help reduce volatility in the markets, and some reassuring words from G-20 leaders (the world’s 20 biggest economies) about their firm commitment to support additional coordinated measures to bolster global output—volatility has declined from the peak level it reached at the end of August (highest VIX intraday spike of 53.29) to approximately a quote of 22 (September 23, 2015), which however is still well above the average level of the past three years (approximately a quote of 14).

According to HSBC’s analysts, the Chinese stocks rout should be nearly over now, since the whole deleveraging process is almost completed. They report, in fact, that the sharp stock decline has been fuelled by the record sell-off of leveraged traders who decided to cut a record pile of debt on speculation that valuations were unjustified. Margin calls and a government crackdown on unregulated loans forced further selling. The balance of margin debt has been stable since declining to its lowest level. A five-fold surge in leveraged wagers helped propel the gauge to a more than 150-percent gain in the 12 months through June 12, 2015. The securities regulator has been taking action against unregulated borrowing. The China Securities Regulatory Commission has also restricted margin positions on the futures market and curbed short selling.

With the improving fundamentals of the US economy, the Federal Reserve has recently stated that it expects to raise interest rates sometime soon and that its monetary-policy tightening will be extremely gradual. Nevertheless, IMF (International Monetary Fund) Managing Director Christine Lagarde since the beginning of the summer 2015 has warned the Fed to remain data dependent and defer its first increase in policy rates until there are greater signs of wage or price inflation than currently evident. In fact, she said that “the IMF thinks that it is better to make sure that data are absolutely confirmed, that there is no uncertainty, neither on the front of price stability nor on the employment and unemployment front, before it actually makes that move”. She also clearly remarked that governments had for too long relied on the supply of cheap cash from central banks that have been running ultra-loose monetary policies and that more fiscal and structural reforms are needed to accompany and eventually take the lead from ultra-accommodative monetary policies. Even the World Bank and other prominent international institutions (i.e., the Organisation for Economic Co-operation and Development-OECD), organizations (i.e., Goldman Sachs) and scholars (i.e., Lawrence Summers, the Harvard University professor and former Obama Administration economic adviser) have supported the IMF’s warning about the potential risks related to an immediate rate-hike decision by the Fed, given the not entirely compelling economic fundamentals of the US economy (i.e., below target inflation and inflation expectations, and a labour market below the maximum employment target), the global slowdown, and the high level of volatility in global equity markets. In spite of the fact that many sophisticated institutional investors reported that they have already priced in the impact of a potential rate hike (monetary policy normalization) by the end of 2015 or in early 2016, the Fed opted for a more prudential approach during their September 17 FOMC (Federal Open Market Committee) meeting, keeping interest rates on hold.

A few days after the policy deliberation, however, Federal Reserve Chair Janet Yellen helped to stabilize sentiment to a certain extent through a speech she gave at the University of Massachusetts, Amherst. In her speech she declared that the Fed is still on track for a possible rate hike in 2015. She showed great confidence in the strength of the US economy and said that she expects the US central bank to begin raising interest rates before the end of the year as long as inflation remains stable and the US economy is strong enough to achieve maximum employment and to keep expectations for prices stable. She also stated that she does not expect that the recent global economic and financial market developments will have a significant impact on the US central bank’s policy. Furthermore, she has also expressed concerns about delaying for too long policy tightening and confirmed her intention to progress with a “quite gradual” pace of future rate hikes. She believes that “a more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data”.

Before Janet Yellen’s speech at the University of Massachusetts and a wave of better than expected economic data about the US economy (i.e., revised second quarter of the year US Gross Domestic Product or GDP growth at 3.9 percent versus the previous estimate of 3.7 percent, driven by stronger consumer spending and construction and a smaller accumulation of inventories), futures traders put approximately a 40-percent chance of an interest rate hike before the end of the year, but after her speech and the new positive economic data, they attach approximately a 50-percent probability of a first rate lift-off in 2015. In spite of growing concerns about the global economy, the new data seem to support the case that the US economy may be gaining enough strength to withstand an increase in benchmark interest rates from the record low levels of over nine consecutive years. In the past weeks and months, uncertainty about the Fed’s plans on policy tightening has led to volatility in financial markets, and the Fed’s decision not to raise rates has reverberated around the world, leading many central banks to take a turn toward easier interest-rate policies. If the stronger recovery of the US economy will be confirmed by robust data in the coming months, the Federal Reserve will have more reliable arguments to support the case for a long-awaited first rise in interest rates in 2015 Yet, major concerns still remain on the current uncertain scenario due to the global slowdown, the wide expansion of the highly leveraged shadow banking, falling commodity prices and falling currency exchange rates, deflationary trends (i.e., Japan is falling back into deflation for the first time since 2013), and the deteriorating outlook for a number of emerging markets (i.e., Turkey, South Africa and Brazil; Standard & Poor’s has recently downgraded Brazil’s sovereign credit rating to junk status).

A number of influential analysts and scholars have instead criticized the FOMC’s decision to keep its key funds rate near zero given the evident signs of recovery of the US economy. Furthermore, they have also argued that pension funds, insurance companies and other investors will continue to receive lower returns unless the Fed starts to normalize interest rates. Bond fund manager at Janus Capital, Bill Gross, in fact, stated the following: “If companies can borrow close to zero, why wouldn’t they invest the proceeds in the real economy? The evidence of recent years is that they have not.” He also added, “Instead they have plowed trillions into the financial economy as they buy back their own stock with a seemingly safe tax advantaged arbitrage. But more importantly, zero destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society.”

As a consequence of a broader economic slowdown, the G-20 leaders recently raised evident concerns about the use of competitive devaluations; however, they currently do not foresee the risk of a global recession. In fact, they believe that growth in some advanced economies remains intact and that monetary-policy tightening in these countries is more likely soon as their economic outlook continues to improve. Furthermore, the G-20 leaders predict that the advanced economies should not be severely affected by the slump in China and in the emerging markets as global economic recovery should gain speed. However, they claim that they will continue to monitor developments, assess spillovers and address emerging risks in order to foster confidence in the markets and to assure financial stability.

They have also stated the following: “We will implement fiscal policies flexibly to take into account near-term economic conditions, so as to support growth and job creation, while putting debt as a share of GDP on a sustainable path. To this end, we will also continue to consider the composition of our budget expenditures and revenues to support productivity, inclusiveness and growth.”

The G-20 leaders consider boosting investments to bolster recovery a top priority, and, in particular, to foster efficient infrastructure investments and support financing opportunities for SMEs (small and medium-sized enterprises), such as the consolidation of best practices in public-private partnership (PPP) models and alternative capital-market instruments. Furthermore, they have also recognized the importance of facilitating financial intermediation for SMEs: improving systems for credit-reporting, lending against movable collateral and insolvency reforms. They also encourage the finalization of the common international standard on the total-loss-absorbing-capacity (TLAC) standard for global systemically important banks and robust higher loss absorbency requirements for global systemically important insurers; the completion of the reforms on OTC (over-the-counter) derivatives contracts; the cross-border access of authorities to trade repository data; enhanced risk-weighted asset calculations for bank capital ratios; strengthened central counterparties’ resilience; and the implementation of the G-20 shadow-banking roadmap.

In early September 2015, People’s Bank of China Governor Zhou Xiaochuan reported reassuring messages to the markets, stating that after the debt-fuelled bubble burst in the country’s equities, China’s stock market has almost completed its correction. He also added that State intervention stopped the freefall in shares and helped avoid systemic risk. Furthermore, he remarked that the yuan exchange rate against the dollar is stabilizing, and that with a reduced leverage ratio, the impact on the real economy should be limited.

Some of the Chinese government’s and central bank’s interventions of the past weeks included the following emergency measures: cutting several times interest rates; injecting liquidity into the interbank money market via short-term liquidity operations (SLO); reducing the Reserve Requirement Ratio (RRR) and the one-year deposit rate; allowing local pension funds to invest up to 30 percent of their net assets in domestically listed shares; imposing a new 20-percent reserve requirement on all currency forward positions; providing a government lifeline to heavily indebted property investors, state-owned companies (debt-for-bond swaps) and local municipalities (local government financing vehicles).

This massive intervention of the Chinese government to rescue the stock market so far has been quite expensive. In fact, according to Goldman Sachs Group Inc., China’s government has spent 1.5 trillion yuan ($236 billion) trying to shore up its stock market since the rout began in the early summer. Furthermore, China’s foreign-exchange reserves fell by $94 billion in August 2015 as the country’s central bank sold down some of its massive stockpile to support the renminbi.

After approximately three decades of breakneck growth (averaging a rate of almost 10 percent of GDP) and its emergence as the world’s second biggest economy, with a GDP of $10 trillion and 1.35 billion citizens, recently China has revised down its estimate of 2014 economic growth to 7.3 percent from 7.4 percent, in a move set to revive concerns about the health of the country’s economy and aims to achieve its annual economic growth target for 2015, set at 7 percent.

Somehow, China’s economic challenges are reverberating through financial markets and threatening the world economy, even though China has expressed a firm commitment to structural economic reforms and to turn what was a high-growth economy fuelled by exports, investment and savings needs into a growth model led by domestic demand and consumption. The change in their economic model, however, will probably require a period of seven to ten years.

China’s housing market has been slowing for most of this year (2015), thanks to a vast overhang of debt-fuelled construction. Due to a sluggish global demand, China’s export sector is currently struggling. The government contributed to bring up share values at the first signs of stock market chaos in July. The subsequent unexpected devaluation of the yuan merely added to the burden for any Chinese company holding debt in dollars. In spite of the current complex scenario, however, China can still unleash significant stimulus firepower.

Moody’s Investors Service maintains its baseline GDP growth forecast of 6.8 percent this year and 6.5 percent in 2016, before falling towards 6 percent by the end of the decade. They also added that the “recent stock market correction is unlikely to have a significant impact on China’s GDP growth. The depreciation of the renminbi so far will also not have any marked economic impact” (Moody’s, 2015). Furthermore, the Chinese government has declared its intention to remain committed to economic reforms that are essential for boosting long-term competitiveness, and it has also expressed its ambition of having the yuan traded as a global reserve currency, joining the IMF’s Special Drawing Rights (internationalization of its currency). Other international institutions and organizations such as IMF (6.8 percent in 2015 and 6.3 percent in 2016), OECD (6.7 percent in 2015 and 6.5 percent in 2016), Barclays (6.6 percent in 2015 and 6.0 percent in 2016) and Goldman Sachs (6.8 percent in 2015 and 6.4 percent in 2016) also estimated quite similar GDP growth rates for China.

Prominent economists, such as New York University Professor Nouriel Roubini, have described the reactions to the Shanghai stock market rout as “excessive, unreasonable and irrational”. Dispelling unreliable rumors, Roubini also added that “the slowdown in China is neither a hard landing or a soft landing, it’s a bumpy landing. It could be better managed, but growth is not likely to be worse than 6.5 percent this year and 6 percent next year”.

Other economists such as former US Treasury Secretary Lawrence Summers and his Harvard colleague Lant Pritchett argue instead that China’s growth could slow to 2-to-4 percent over the next two decades. Economists have frequently questioned the methodology underpinning Chinese statistics, given discrepancies between regional and national growth figures, data collection shortfalls and, at times, a lack of transparency. Using alternative metrics for measuring economic growth based on freight rates, electricity output and other data, for example, analysts of Citibank recently reported they believe China’s actual growth rate could be closer to 5 percent rather than 7 percent.

Signs of decelerating economic growth in China were confirmed in early September 2015. The value of imports fell 14.3 percent year-on-year in renminbi terms in August, a steeper decline than July’s 8.6 percent fall, the 10th consecutive fall. Exports dropped a more modest 6.1 percent from a year ago, against an 8.9-percent drop in July. As a result, the trade surplus jumped nearly 40 percent month-on-month to RMB368 billion ($57.8 billion). As a consequence of the slowdown, China’s demand for key commodities such as crude oil and iron ore also fell with cascading effect on its global trading partners. Caixin/Markit’s factory purchasing managers’ index for August 2015 sank to 47 in September from 47.3 a month before, the lowest level since April 2008. The reading continues to be below 50—the level that separates expansion from contraction. New orders and new export orders decreased at a faster pace in August, as well as output and employment. This weaker performance will probably trigger further intervention by the government to fine-tune fiscal and monetary policies to ensure macroeconomic stability and speed up structural reform. However, as previously stated, recent trade data from China seems to portray a deteriorating picture of economic slowdown, as indicated by a sharp decline in the value of imports and exports, which amplifies concerns about the country’s potential ripple effects on emerging markets and advanced economies.

According to Roubini, the Chinese stock market collapse was different from previous ones, since “the Shanghai bourse is largely closed to the rest of the world and is thinly owned by Chinese citizens, while the country’s banking system is state-owned and therefore has the entire resources of the Communist regime to avert a financial meltdown”.

As the Chinese economy began to slow down, SMEs reduced their investments and borrowings. According to John Mauldin, in order to keep the momentum and assure steady growth, authorities encouraged frenzy access to the stock markets by a horde of new individual investors; as a consequence, the Shanghai Composite Index took off in 2014 and 2015. He also added that “investors both large and small bought stocks with huge amounts of borrowed money. The growth in the number of investment accounts has been nothing short of phenomenal; something like 3.7 trillion RMB of borrowed money hit the stock market” (Mauldin, 2015).

China is currently going through a difficult and long transitional phase (probably five to ten years) from an investment-led economy to one more dependent on consumption and services. If they are not able to rebalance their economic model, they may face economic and political turmoil. The Chinese government and People’s Bank of China will probably aim to stabilize and boost economic growth through additional aggressive fiscal policies, monetary policies and structural reforms, and by providing liquidity to the banking sector. Chinese foreign-exchange reserves are substantial, although they have sharply fallen in the last year.

If things go awry, the IMF, central banks and G-20 economies will probably step in to assure the necessary support to stabilize the economy and to reduce any potential spillover effects to the emerging markets and to advanced economies. In fact, spillovers of a potentially worsening crisis in China could trigger systemic risks (in case of no bailout) in its banking and shadow-banking sectors, credit and derivatives markets, thus leading, in the worst-case scenario, even to banking and liquidity crises (a potential risk also confirmed by Bank for International Settlements-BIS) that ultimately might affect the real economy and global markets.

China will need to smoothly undertake a difficult transition from a government-controlled economic model to an open financial-market model (market liberalization) in order to improve capital allocation and to rely on market prices to allocate resources. Furthermore, they will need to expand the private sector, which has been the engine of China’s growth. The process towards a real free market economy will be quite challenging for China in the short-term since it requires having a truly independent central bank (monetary-policy independence), free capital flow and floating exchange rates. However, in a sharp reversal of its market-liberalization rhetoric, soon after the recent equity-market correction, China (the State Administration of Foreign Exchange – SAFE, the unit of the People’s Bank of China in charge of managing the currency) has tightened its capital controls and has ordered financial institutions to step up checks and strengthen controls on all foreign-exchange transactions (i.e., the practice of over-invoicing exports) in order to reduce massive capital flights.

The Chinese economy has grown to become, over two-and-a-half decades, the world’s largest manufacturer, largest merchandise trader and largest holder of foreign reserves. After the global financial crisis, debt and high leverages (driven by “easy credit” and “shadow banking”) in China have exploded (i.e., stirred by local government off-balance sheet financing vehicles). As reported in a study of the McKinsey Global Institute in early 2015, China’s debt has roughly quadrupled since 2007; and in particular in 2015, the ratio of corporate debt to GDP in China reached a staggering 125 percent (MGI, 2015).

Regarding the same topic, the author of this article reported in the paper titled “Predictable and Avoidable: What’s Next?” published in September 2014 in the Journal of Governance and Regulation (Volume 3, Issue 3, 2014 Continued- 1) the following words: “In 2013 there is still a high level of uncertainty in the global economy which makes the long-term scenario quite complex to be predicted. Some of the highly interconnected factors that contribute to this scenario are: ….the uncertainty about a change of pace of the so-called emerging markets and the threat of China’s credit bubble and its huge ‘shadow banking’ sector” (Pezzuto, 2014).

I also stated in an interview with CNBC on December 3, 2014, that “economies often use shadow banking, easing of credit standards (massive debt expansion), and high degree of leverage (highly leveraged bubble) in the attempt to revamp economic growth when it is decelerating, but these loose macroprudential regulations are not risk free”. This was particularly true of China, especially after the 2008 global financial crisis, since the rest of the advanced economies were badly hit by the Great Recession, and China became the global growth locomotive. In those years, in fact, China’s share of investment in GDP rose just as the growth of potential output declined. In that same paper of 2014 (“Predictable and Avoidable: What’s Next?”), I also reported the following: “In its 2014 annual report, the BIS warned of the risks brewing in emerging markets, setting out early warning indicators of possible banking crises in a number of jurisdictions, including most notably China. Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on, it said. The BIS, the bank for central banks, has been a longstanding sceptic about the benefits of ultra-stimulative monetary and fiscal policies, and its latest intervention reflects mounting concern that the rebound in capital markets and real estate is built on fragile foundations” (Fleming, Jones, BIS 2014).

Furthermore, the author of this article has reported in the book titled Predictable and Avoidable: Repairing Economic Dislocation and Preventing the Recurrence of Crisis, published by Gower Ltd. in 2013, the following remarks about China: “Analysts and Western rating agencies have raised some concerns since 2011 about emerging markets’ financial stability (in particular in China), due to the drastic increase of the ‘shadow banking’ industry in order to remove banks’ funds from their balance sheets. The Financial Times reports a 600 percent increase in 2012 in shadow financing activities related to brokerage in China” (Rabinovitch, 2013).

More worryingly, in recent years Chinese corporations and banks have borrowed massive amounts in US dollars, when the currency was cheap and rates were low. Thus according to some analysts, if the Chinese central bank now decides to launch full-fledged quantitative easing to shore up its economy, it might not help solve the problems; perhaps it might only encourage more debt-led growth and foster additional financial fragilities. Furthermore, it seems that currently only a limited portion of the dollar-denominated corporate bonds of the emerging markets are linked to instruments for hedging foreign-exchange risk.

What’s next for China and the USA?

Most likely, hoping not to have systemic risks, the Chinese government will try to prop up the stock market and to stabilize the economy and the renminbi through various interventions. The People’s Bank of China seems to have plenty of room for additional monetary stimuli; the IMF seems to encourage China to float its currency in order to be included in the SDR (Special Drawing Rights). And the government will try to speed up structural reforms to complete the rebalancing of the economic model. So, the country should have the time and resources to handle the current difficult transition phase. Since China’s foreign reserves include a large amount of US Treasuries, the US government and the Fed are certainly very concerned about the possibility that China might undertake a massive sell-off of US Treasuries in an attempt to support the renminbi.

In spite of the fact that the Fed, like other central banks, should remain independent from political influence and global externalities, and it should be mainly focused on the health of the US economy when setting its monetary policy, there is no doubt that in today’s complex, highly interconnected and globalized world, it would be difficult for any central bank not to consider in their global economic outlook and data-dependent analyses the economic and financial shocks of leading global economies. The collapsing Chinese stock market, plunging commodity prices, global slowdown, geopolitical risks and the intensifying currency wars will inevitably affect, directly or indirectly, all central banks’ policies and global economic- growth expectations. A turmoil in the emerging markets may eventually lead the world economy into a slump. Furthermore, since the next presidential election in the USA will be in 2016, geo-political scenarios will continue to have a great influence on the Fed’s policies.

The stock-market and credit bubbles in China, the strength of the dollar relative to emerging-market currencies and commodity routs could all affect global earnings growth. Given the current scenario, it would be impossible to imagine a complete decoupling of the Chinese crisis on other economies. Sooner or later, the effects of the bubbles and economic slowdown will have an impact on the global markets. Higher interest rates will raise borrowing costs for consumers and companies, possibly hurting spending and economic growth. The appreciation of the dollar, devaluation of the Chinese and other currencies, and further decline of oil and commodity prices are complicating factors in predicting the pace of global growth and the Fed’s monetary-tightening policy.

Economists at Barclays Capital have recently predicted that a rate hike will occur in March 2016, stating that “it is unlikely to begin a hiking cycle in this environment for fear that such a move may further destabilize markets”. However, given the fact that the FOMC seems to have posed significant attention on financial stability considerations and improving US economic fundamentals, it might still be possible for a first rate hike before the end of 2015 in order to signal confidence to the markets in reaching the Fed’s inflation target in the medium-term and in the strength of the recovery. Perhaps they might opt for just a symbolic first hike.

Global economic growth requires more capital investments and infrastructures, innovation, and increased aggregate demand and inflation. Flooding the markets with massive liquidity measures (QEs) without adequate consumer and business confidence, fiscal policies and structural reforms towards enhanced competitiveness is unlikely to generate long-term economic benefits, such as growth, higher employment and participation rates, higher productivity, and real competitive advantages. Since the global financial meltdown of 2008, central banks have flooded the markets with massive liquidity for several years (conventional and non-conventional monetary measures) and close-to-zero-percent interest rates. More than 20 countries are in the process of quantitative easing, and pressures on currency devaluations seem to persist. These massive capitals have moved around the world, from one economy to another (carry trade), contributing also to the rise of bubbles (credit has grown more than production), bad investments and bad debt.

These emergency monetary policies (QE) are appropriate in the short-term, given the severity of the global financial crisis and the Great Recession to stave off the threat of deflationary spirals, but when they are prolonged for a considerable period of time (many years or decades), and are not integrated by aggressive fiscal stimuli, and effective structural reforms, they may create severe distortions in the markets and bubbles. Now it is time to ensure that the financial markets are properly regulated and controlled, that revolving doors and conflicts of interest are reduced, and that short-term goals of business and politics do not prevail on economies’ long-term growth, employment and sustainability goals.

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