China’s central bank is on a mission to stop the rot in the world’s second biggest economy. Overnight, the People’s Bank of China (PBoC) wasted no time in trying to restore some confidence across markets.
First, the PBoC cut interest rates by 0.25%, reducing the official cash rate to 4.6%.
It then followed this by lowering capital requirements for banks. The reserve requirement ratio (RRR) fell by 0.50% to 18%. The RRR simply refers to the amount of money banks must hold in order to lend. The PBoC has made it easier for banks to lend to borrowers.
If you’ve paid attention to the turmoil engulfing the globe in the last few days, you’ll know why China’s panicking.
The stock market rout overwhelming international markets is a serious cause for concern. For one, it destroys the wealth of many unassuming investors. Equally important is what it tells us about the broader economy. At present, investors are signalling that China’s a sinking ship.
We’ve known for years that the Chinese market is overvalued. It grew from a little over a trillion to almost $10 trillion in the space of a few years. We also know why this mad rush took place.
Chinese officials promoted stocks, ushering people from an overheating property market at the time. That kept real estate cool for several years, but it drove Chinese stocks into a frenzy. P/E ratios rose to new heights despite a lack of underlying growth to support them.
Every mum and dad investor in China got on the bandwagon. New trading accounts were counted in the millions on a monthly basis. A major property market crash was averted. But it only served to set up a collapse in stocks.
Now stocks are falling even faster than they rose. The share market declined 8% on Monday alone, capping off a torrid couple of months for investors.
That, above all, is the reason why Chinese officials are turning to easier lending to save the day. By injecting more cash into the economy, they hope to keep the ruse going for a little longer.
Yet unlike economic data, Chinese authorities can’t hide the carnage on the markets. You can fudge 7% growth rates with a bit of creative accounting. But stock market trends are clear for the entire world to see. Unfortunately, the current collapse tells us everything in China is sickly. Authorities are acting quickly to fix the damage. But it’s getting harder to paper over the cracks emerging in the Chinese economy.
You might recall that the PBoC took similar measures on more than one occasion this year. Lowering rates and capital requirements are tried and tested measures — that’s all central banks can do after all.
They inject cash into the system, kicking the can down the road to deal with at a later time. But lowering rates and lending requirements is a short term measure. At best, it helps spruce borrowing in the short term. In the meantime, the real economy worsens. And it sets the economy up for a harder crash down the road.
The difference between China and Australia, or the US, is that it can ease its monetary policy further. Interest rates and capital requirements have plenty of scope to fall. At 4.6%, interest rates remain lower than in the US (near-zero) and Australia (2%).
Yet as we’ve seen in both the US and Australia, laxer monetary policy doesn’t work in the long run. It props up assets like stocks and property. But it comes at the expense of initiatives targeting real long term growth.
China: The world’s biggest worry
China’s problems concern the rest of the world too. After all, a Chinese collapse is nothing short of disastrous for the global economy. Why? Because the world, from Australia to Europe, depends on China’s wellbeing.
Our consumers buy Chinese goods. Our exporters sell China materials they need. That, as in the case of Australia, can support entire economies.
Right now, global markets look at what’s happening in Chinese stocks with dread. This is happening despite the fact that Chinese markets are relatively insular. There isn’t much, if any, overlap between Chinese and international investors on stock markets.
In that respect, the latest stock market correction is strictly a Chinese problem. But China’s stock market troubles affect the world economy in indirect ways. How? Because it reflects the direction of the broader economy. If China’s economy is slowing, then global markets start to panic too. We’ve seen exactly that in the last few days.
The Chinese ‘Black Monday’ became a global problem in no time at all. The S&P500 has its worst day since the 2008 global financial crisis on Monday. The ASX lost $60 billion, or 4%, of its market cap in the space of a day.
But the real worry is that China is nowhere near bottoming out just yet. If China is slowing as fast as many now expect, everyone loses. The signs are that this is exactly what awaits us.
Chinese demand could remain sluggish for months to come. You can imagine what that’ll do to Aussie commodities exports looking ahead. Not only is China’s demand for commodities slowing, but its currency devaluation makes Aussie exports more expensive too. That’s a nightmare combination for the Australian government, which still depends on mining taxes for much of its revenue base.
Where to next?
Over the course of the second half of the year, things could get much worse before they improve. And it’s a big question as to whether the new year will bring any kind of reprieve either.
What’s happening now has the potential to dwarf the GFC crisis. Why? It’s because central banks across the developed world are hamstrung. China has scope to prop up its flagging economy a little longer. Elsewhere though, monetary policies have been exhausted for the most part.
In the world’s biggest economy, the US Fed is contemplating when to raise rates. But they can forget anything of the sort in this landscape. The last thing the US needs now is higher rates at a time when China’s embarking on a fresh round of monetary easing.
This means that fears over China won’t disappear anytime soon. China will remain the flashpoint that could tip the world over the edge into economic chaos. There are few signs that its economy will improve anytime soon.
With manufacturing crashing to six year lows, domestic demand for goods is falling. At the same time, the global economy is slowing too, reducing the demand for Chinese exports.
As the Chinese economy goes, so too do global stock markets.
The onus on Chinese authorities is to maintain growth rates of 7%. Considering there’s barely any growth to speak of, it means only thing: more stimulus.
At the same time, rate cuts should weigh further on Chinese currency. The yuan’s recent devaluation spooked markets, and for good reason too. A cheaper yuan makes Chinese exports less expensive, while making imports costlier.
For Chinese investors, the big question is whether people will flock back to property again. If property again becomes the go-to investment option, there’ll be renewed pressure on real estate. But it could also lead to an influx of Chinese investors into the Aussie housing market too.
Either way, it’s a turbulent time ahead for the Chinese economy. The uncertainty over China’s economic health will affect the world economy at large too.
As the era of monetary easing comes to an end in the developed world, it’s just picking up in China. But we all know how that story will end.
Contributor, The Daily Reckoning
PS: Chinese stock markets aren’t the only ones with dark clouds hanging over its future. The Aussie share market has its own problems to contend with. The 4% market cap loss this week is a sign of how quickly things can spiral out of control.
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