World asleep as China tightens deflationary vice
Comment of the Day

February 13 2014

Commentary by David Fuller

World asleep as China tightens deflationary vice

We keep our fingers crossed as we glimpse the first foam of a deflationary Ch'ient'ang'kian coming our way from China. The world's central banks have no margin for error

Here is the opening from this sobering column by Ambrose Evans-Pritchard:

China's Xi Jinping has cast the die. After weighing up the unappetising choice before him for a year, he has picked the lesser of two poisons.

The balance of evidence is that most powerful Chinese leader since Mao Zedong aims to prick China's $24 trillion credit bubble early in his 10-year term, rather than putting off the day of reckoning for yet another cycle.

This may be well-advised for China, but the rest of the world seems remarkably nonchalant over the implications. Brazil, Russia, South Africa, and the commodity bloc are already in the cross-hairs.

"China is getting serious about deleveraging," says Patrick Legland and Wei Yao from Societe Generale. "It is difficult to gently deflate a bubble. There is a very real possibility that this slow deflation may get out of control and lead to a hard landing."

Zhang Yichen from CITIC Capital said the denouement will be a ratchet effect since China has capital controls and banks are an arm of the state, but that does not make it benign. "They are trying to deleverage without blowing the whole thing up. The US couldn't contain Lehman contagion, but in China all contracts can be renegotiated, so it is very hard to have a domino effect. We'll see a slow deflating of the bubble," he said.

What is clear is that we are dealing with a credit expansion of unprecedented scale, equal in size to the US and Japanese banking systems combined. The outcome may matter more for the world than anything that the US Federal Reserve does over coming months under Janet Yellen, well signalled in any case.

Societe Generale has defined its hard landing as a fall in Chinese growth to a trough of 2pc, with two quarters of contraction. This would cause a 30pc slide in Chinese equities, a 50pc crash in copper prices, and a drop in Brent crude to $75. "Investors are still underestimating the risk. Chinese credit and, to a lesser extent, equity markets would be very vulnerable," said the bank.

David Fuller's view

China’s longer-term potential would be enhanced by some judicious deleveraging of its credit bubble.  So let us hope that Zhang Yichen from CITIC Capital, quoted above, is correct in his assessment.  If not, the markets should give us some early warnings. 

In particular, watch the industrial commodity markets.  They are all in the Chart Library and they are not confirming Societe Generale’s hard landing signals mentioned in the last paragraph quoted above.  Additionally, the Continuous Commodity Index (weekly & daily), which also contains precious metals and foods, has been recovering recently.  If China really was experiencing a hard landing, rather than an orderly deleveraging, I would expect CCI to be breaking below 500.  However, it has rallied to its highest level since last June. 

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