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New Year, Old Problems

2016 has not had a fresh start. The year begun in the same way 2015 ended: the Chinese stock market plunged once again, as did the oil price. The Dutch stock exchange experienced the worst first week in its history; many others suffered heavy losses. There is a market belief that January predicts how the rest of the year will go. If this is the case, 2016 is looking all but rosy. But there appears to be more at play then just bad omens. George Soros, a well-known economist and predictor of past recessions, has recently compared the current global situation to that at the start of the financial crisis. Many others agree with him that the current economic climate looks rather dangerous. Are we really are on the brink of a new recession and if so, where will this trouble come from? In this article I discuss some of the issues that are distressing markets around the world and assess whether or not a new crisis is really just around the corner.

At the centre of any recession lies slowing growth. The World Bank, the OECD and several other institutions revised down their forecasts for global GDP growth this year. Slower global growth has many causes varying from country to country but overall three related issues are considered the most important. First, global trade is seeing a significant collapse. The CPB world trade monitor reported mostly decreases in trade volume for most of 2015. Another measure of trade, The Baltic Dry Index (which measures shipping costs for commodities) has been falling rapidly since August 2015. Trade and global GDP historically have moved together, the apparent breakdown of this relation is worrying investors. Secondly, lower demand from emerging economies is depressing growth. Ever since the crisis, emerging economies have pulled the world economy forward while the developed economies slowly recovered.  As argued in this article, that chapter ended last year and a new leader of growth has yet to stand up. Thirdly, geopolitical worries are cumulating around the world, threating the stability of economies. In the Middle East, Sunni and Shi’i tensions are again reaching high levels. In Europe, worries about the future of the Schengen treaty and a possible Brexit have only intensified this year. All these development fuel uncertainty in the global markets.

Though the above shows plenty of cause for concern, it does not directly imply disaster on the scale of the financial crisis. What makes Mr. Soros link the current situation to that of 2008 is China’s massive pile of debt. As the Chinese economy grew exponentially over the years, so did its credit consumption. A recent study by McKinsey found that from 2007 to 2014, Chinese debt to GDP went up from 158% to 282%. A number even more staggering when taking into account the pace at which GDP grew over that same period. As the Chinese economy slows down, the sustainability of this debt becomes more and more worrisome. Economic theory suggest that as an economic boom comes to an end, the financial speculation (such as the taking on of more and more debt) it has fuelled eventually becomes unsustainable and a credit crisis follows. The moment this debt bubble burst is called the “Minsky moment”; named after Hymen Minsky, an economist known for his work on financial market instability. At the start of the crisis in 2008, the term Minsky moment suddenly became popular again and a quick google search for 2016 shows some regained attention for the topic. 2016 could prove to be China’s Minsky moment. To draw a final link to 2008, the McKinsey report finds that half of all Chinese debt is linked to the real estate market; a market known to be a breeding ground for financial bubbles.

As it seems, Mr. Soros comparison to 2008 is valid and a true cause for concern. Yet there are several footnotes to the Chinese situation that distinguish it from the US circa 2008. First, the Chinese government has a firm grip on the economy and both the power and the means to intervene were something to happen. Most of the outstanding debt is held up with firms and financial institutions. Where they to collectively default on their debt, China could bail them out by making use of the massive amounts of reserves they hold. Were these measures not enough to avert the credit crunch from turning into a recession, the Chinese government could help the broader economy by devaluing the Yuan and improving competitiveness. Noted should be that this last scenario is quite treacherous. A devaluation to support competitiveness has the risk of triggering devaluations by competitors (most other Asian countries),which could result in a nasty currency war.

A second reason why fear for a repetition of 2008 appears to be overblown is that the Chinese financial system is fairly isolated. This means that were a credit bubble to burst, there is little risk of it spreading to other markets (as was the case in the US). Where a Chinese financial crisis to happen, this confinement will limit its effect on the global economy. But only partly: many countries and firms all over the world are heavily dependent on Chinese demand, which will undoubtedly take a hit in case of a crisis. As we have seen over the last year, even a slight weakening of the Chinese economy has strong effects around the globe; imagine what a full out recession would do.

A recent survey by Bank of America Merill Lynch found that 52% of interviewed fund managers considered a Chinese recession the main risk to their portfolio. This article argued that these worries are not unfounded: the situation in China remains about as questionable as the data supplied by the Chinese government. However, comparisons to the situation of 2008 appear to be overblown when taking a closer look. The situation is undoubtedly worrisome, but there are enough reasons to believe the government will be able to counter a large default on debt and prevent a recession. The world economy right now is in a feeble state, growing but not convincingly. Yet it is still going to need a heavy push were it to fall back into a recession. The bursting of the Chinese debt bubble does not yet seem a strong enough candidate for this job.


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