Professor Robin Bladen-Hovell of Keele Management School warns that China’s struggling economy is a problem for us all, having a similar root to our own recent financial crash, and with potential world-wide impact. Please drink responsibly.
Although it is usually January that is described as the month of empty pockets, recent market performance will have left many thinking that February is little better. Stock market turbulence that characterised 2015 re-emerged in last month with falls on the Chinese market driving the price of American and European stocks lower. This has been followed this week by further declines in the Far East, with London and New York falling as well as the rout spread. In the UK, the FTSE100 fell to a three-year low, continuing a decline that began last April. In the ten months since, close to £400 billion has been wiped off the market value of the leading UK companies with RBS analysts in January advising investors to sell, warning them of “a cataclysmic year”. If the current signs are anything to go by, many investors are taking this advice to heart and the market has become increasingly bearish as a result.
These movements all form part of what George Osborne recently referred to as the “cocktail of threats” facing the UK economy, a cocktail which has the underlying weakness of the global economy for its base in place of alcohol. Like all cocktails, however, ingredients matter and in the shaker we find constituent parts that are drawn widely with a strong after-taste associated still with the financial crisis of 2007/8.
At its root, the financial crisis was an old fashioned banking crisis. On the back of rising house prices and falling interest rates, the US banks undertook the very rapid development of the so-called sub-prime mortgage market. The sub-prime nature of this market is these loans are made to individuals who have irregular income, poor credit history or, as some reports subsequently found, to individuals who did not possess the paperwork to even be in the US. By 2005 some 20% of US mortgages fell under the sub-prime heading with the influx of funds pushing the property price bubble higher still. All this came to an end, however, with the Federal Reserve’s decision to tighten US monetary policy in mid-2004. Households who previously had struggled to pay their mortgage when interest rates were low found themselves unable to maintain payments as rates rose with dire consequences for banks and other institutions who relied upon these payments continuing in order to sustain their business model.
What surprised many onlookers at the time of the crisis was how far and how fast the repercussions from US mortgage crisis spread. What was revealed as the crisis unfolded was an intricate web of little understood financial claims that spanned the global economy. Sub-prime mortgages that had been repackaged to form the basis of mortgage-backed bonds and sold to financial institutions globally lay at the heart of these claims. Along the way, everyone seemed to have forgotten that the income paying the coupons on these mortgage-backed products was extremely risky. Once the risk became apparent, however, financial institutions around the world found themselves akin to latter-day fairy tale emperors, with wardrobes stuffed full not with shiny new clothes but rather, with relatively worthless pieces of paper.
The crisis spilt over into the real economy rapidly. Bank lending to households and firms dried up as the financial sector struggled to rebuild its balance sheet; households and businesses lost confidence, fearful of the future, and growth rates for the leading industrial economies fell precipitously. The rescue package, which involved governments socializing the toxic-debt obligations of the financial sector, has itself proven inadequate, with risk of default being transferred rather than mitigated. A financial crisis of the banking system became a sovereign debt crisis as governments around the world found themselves facing a deteriorating financial position. In Europe, the problem was particularly acute in the so-called PIIGS countries, Portugal, Ireland, Italy, Greece and Spain. Austerity, in various forms, has been the price imposed by governments across Europe seeking to demonstrate their financial integrity and convince financial markets that the level of government borrowing is sustainable. Of course, the unfortunate side-effect of the austerity measures has been a further weakening of what was already a flagging level of global demand.
The current problems in China complicate this picture further. Surprisingly, many of the issues in China are similar to factors underlying the crisis in the West: bubbles in the property market and the stock market fed by excess liquidity, driving up asset prices, and encouraging investors to speculate on the back of borrowed money. This state of affairs has changed as growth in the Chinese economy has faltered and market confidence has declined as the downturn has taken hold. The result has been a roller-coaster ride since June last year for Chinese investors, as Chinese companies on the Shanghai market lost almost half their value.
The potential for the problems in China to spill over on to the rest of the world is considerable. Global financial markets are clearly inter-connected with volatility on one market reflected in market movement elsewhere. In addition, the commitment of the Chinese authorities to support the market leaves open the possibility that they may withdraw their support at some point should they decide their position is unsustainable. The prospect that the authorities might relax their position in the foreign exchange market with the Renminbi being allowed to devalue against the Dollar should that happen, cannot be discounted. Such a devaluation, while having the effect of making Chinese goods cheaper on world markets, at least in the short-run, would adversely affect western economies, depressing US and European growth still further.
From the British perspective, the current difficulties in China are being felt through a variety of channels. Of particular importance and as highlighted by the recent market turbulence, is the exposure of British (and European) banks to potential default by companies in the commodity sector. These companies are heavily levered having borrowed extensively to finance investment and the declining price of oil, copper and other commodities is placing the sector under considerable strain. In manufacturing, job cuts at Port Talbot reflect similar problems of oversupply in the global steel market with the strength of Far East competition being felt in what is a very tight market. Recent developments are also causing concern about the sustainability of government’s budgetary position over the longer-term, with warnings from the Institute of Fiscal Studies that the Chancellor may need to make deeper cuts to spending or raise tax rates if he is the achieve his fiscal target by the end of the parliament. The budget in March may reflect some of these concerns.
Concern will, of course, deepen considerably if the Chinese authorities are unable to secure a soft landing for the Chinese economy. A hard landing has the potential to reduce global output growth and given the current state of government finances around the world, it is unclear whether Central Banks and Treasuries have the capacity to mitigate the adverse consequences from such a shock. This, possibly, is the most sobering thought to associate with the current cocktail.
Robin is a member of the Centre of Economics and Management at Keele Management School. Please click here for more information.