The hefty falls in several major share markets last week, including the Australian share market, provided a reminder of how much local and international economic and financial prospects are determined these days by what is happening in China. A slew of July economic readings out of China released last week showed an economy travelling weaker than the last official GDP reading for Q2 2015 of 7.0% y-o-y and with worse than expected deflationary pressure in producer prices to boot. China is providing less momentum than hoped for to global growth and at the same time is exporting disinflationary pressure to the rest of the world too. The news was even worse for a major commodity supplier to China, such as Australia because two of the July economic readings that showed amongst the worst slippage were industrial production, down to 6.0% y-o-y from 6.8% in June and urban fixed asset investment spending, down to 11.2% y-o-y from 11.4% in June.
Also, as far as Australia is concerned, other important export markets in Asia are likely to be negatively impacted too if China is not going so well. China’s international trade data for July made particularly dismal reading with exports down by 8.3% y-o-y and imports down by 8.1% y-o-y. As an increasingly important Asian intra-regional trade hub China’s trade weakness may well signal soft international trade more generally in Asia.
China’s apparent policy response to the weak trade data report has been to depreciate its currency and by more than 3% against the US dollar over two sessions. The authorities have also indicated that the sizeable depreciation reflected a desire for the currency to move in a wider band, more reflecting market forces and a prelude to a time when the currency will float more freely and take its place eventually as an IMF SDR currency becoming an international reserve currency befitting the currency of the world’s second biggest economy. Looked at in this light, China’s currency move last week should not have triggered as much movement in international capital markets as it did. It was a move that was always going to happen at some stage.
What made the Yuan move more of a negative influence for international financial markets was firstly that it could be construed as a sign that the authorities in China are struggling to achieve planned economic growth (7.0% y-o-y) and secondly that it may foster currency wars with other countries depreciating their currencies further. On both counts, market concerns are probably misplaced.
The move by the authorities depreciating the Yuan was the latest in a suite of policy moves aimed at fostering stronger growth in China. The first move on the policy front was monetary policy easing reducing official interest rates and banks’ reserve ratio requirements. Monetary policy has been eased on four occasions since late 2014 and is likely to be eased further. Fiscal policy moves include easier borrowing conditions for local government and planned substantial government spending on housing and urban renewal as well as more improvements to public transport. As always, policy moves act with a lag and by late this year or early 2016 it is highly likely that the positive impact from the various policy moves, including the latest currency moves, will be starting to show. It is more likely, not less likely, that China will grow faster down the track.
In terms of currency wars, China’s move on the Yuan has been very modest relative to much sharper falls in several Asian currencies such as the Malaysian Ringgit and Indonesian Rupiah. Moreover China’s move reflects recognition that the managed exchange rate had become very over-valued as the sharp falls in China’s exports and producer prices attest. Realistically, the authorities could depreciate the Yuan another 5-10% to better reflect China’s economic conditions.
Even though we expect financial markets to take a rather more positive view of developments in China over coming weeks than the initial negative reaction to the Yuan depreciation last week, Australian financial markets may take longer to improve given the heavy weighting in the local share market to resource stocks. A weaker Yuan means that China’s own domestic suppliers of coal and iron ore may be slower to adjust down their output than previously thought likely. Burgeoning international supply of industrial commodities, especially from Australia, adding to stickier domestic supply inside China and meeting demand from China that is still growing less fast implies that falls in commodity prices still have some way to go.
The weak price outlook for Australian industrial commodity exports means that cutbacks in mining investment spending are really only just starting. Australian economic growth will be travelling not much better than stalling point well in to 2016. Eventually China will come to the rescue again, but this time around China’s growth will not be as strong as it was in the previous growth cycle and there will be considerable over-supply of industrial commodities on the market to work off too. Australia will need growth accommodating policies for at least the next year or two in our view. The risk remains that the RBA will cut the cash rate further, probably in November. More certainly, Australia’s cash rate is unlikely to be above 2.0% through the remainder of 2015 and through 2016.