Significant changes are taking place. As we noted several weeks ago, for the first time in 27 years wealth is not flowing into emerging markets. It’s flowing out.
The global economy everyone has known since the late 1980s is being stood on its head. Symbiotic relationships of production and consumption, of savings and debt, of eastern and western push and pull are backing up. For 2015, net outflows from emerging markets are projected at $540 billion.
China, of course, is the major focal point. From what we gather, $140 billion vacated China in August alone. That amounts to over $1.6 trillion on an annualized basis.
Naturally, this is causing quite a disruption to international currency markets. If you recall, Beijing had to execute a surprise devaluation of the Chinese yuan several months ago. Too much steam had built up behind their dollar peg…they had to let some out before the top blew off.
At the same time, with all this money exiting its economy, China must support the yuan in the foreign exchange market. They want to preserve their dollar peg as much as possible. But they also want to initiate and manage further devaluations before the market forces a crisis.
Fade to Black
To do this, they’re liquidating some of their massive hoard of U.S. treasuries. So far, China has sold about $200 billion of their treasuries. Over the last several months, treasury yields – which move inverse to price – have been going down. If China’s selling treasuries, shouldn’t yields be going up?
Not exactly. The treasury market is very large…nearly $13 trillion. Plus, all the money vacating China’s economy, and other emerging markets, must flow somewhere.
Some of it is likely flowing into treasuries. Perhaps some is also going into gold, which has jumped $60 per ounce over the last 30 days. Maybe some has supported Wall Street’s recent bounce.
But there’s nothing that says this will continue. Today’s buyer of U.S. debt could become tomorrow’s seller. Obviously, yields will rise at some point in the future. Then the low interest rate world that borrowers and Congress have known and loved will fade to black. In other words, debt payments would become more expensive.
“If interest rates on the federal debt should return to their level in 1995,” explains Kevin Williamson for National Review, “then we’re going to be paying $1.4 trillion a year just in interest on the existing debt; which is to say, interest payments alone will account for 45 percent of all federal taxes that will be collected in 2015.”
The point is China’s economy is deflating. Beijing’s efforts to prop up the yuan are futile. They won’t fix the fundamental market distortions and malinvestments borne out of years of cheap credit. Financial market’s will ultimately correct the capital misallocations despite the government’s attempts to stand in the way.
Moreover, there will be implications for the U.S. and the global economy. In terms of GDP, China is the world’s second largest economy. According to the International Monetary Fund, and the notion of purchasing power parity, they’re the world’s largest economy. By either account, deflation in China also means a deflating world economy.
This phenomenon can be best observed by watching industrial commodity prices. Debt fueled growth in China resulted in false demand. Mining companies ramped up production to meet this demand. That false demand has been cut off at the knees. Copper, for instance, is down about 50 percent over the last five years.
But there are also secondary consequences. Job losses. Downsizing. Mass bankruptcies and defaults. These are all examples of collateral damage coming from the whipsaw of the wealth exodus from emerging markets. Interest rates in the U.S. may also get pulled up once the first flood of money from emerging markets back into the U.S. runs its course.
Keep in mind, there’s nothing the Fed can do about it. At zero interest rates, any further monetary extremism would be as crude as a Clydesdale horse urinating on asphalt. Though it would ensure the future cycle is increasingly more profane.
for Economic Prism