The global economic landscape is undergoing profound transformations. As highlighted a few weeks back, wealth is, for the first time in nearly three decades, leaving emerging markets instead of flowing into them.
This shift is upending the economic dynamics that have defined our world since the late 1980s. The interconnected web of production and consumption, alongside savings and debt, is experiencing significant disruptions. Current estimates predict net outflows from emerging markets to reach $540 billion in 2015.
China is at the epicenter of this economic upheaval, with approximately $140 billion exiting the country in August alone—translating to an annualized loss exceeding $1.6 trillion.
This situation is creating considerable turmoil within international currency markets. You’ll recall that just a few months ago, Beijing executed a surprising devaluation of the yuan, as the pressure had built to a critical point, necessitating a controlled release before it escalated into a crisis.
While substantial capital exits its economy, China’s priority remains the support of the yuan in foreign exchange markets. They aim to maintain their dollar peg and strategically manage future devaluations to avert market-triggered crises.
Fade to Black
To achieve this, China has started divesting from its extensive holdings of U.S. treasuries. Recently, it has sold around $200 billion worth of these treasuries. Typically, one would expect treasury yields— which move inversely to prices—to rise when significant selling occurs. However, this is not necessarily the case.
The treasury market is vast, encompassing nearly $13 trillion. Furthermore, the money leaving China and other emerging markets needs to find a new home. A portion likely flows into treasuries, while some may be redirected into gold, which has surged by $60 per ounce in the past month. Others may have bolstered Wall Street’s recent recovery.
Yet, this trend may not be sustainable. Today’s buyers of U.S. debt could easily be tomorrow’s sellers. It is inevitable that yields will rise at some point. When that happens, the era of low interest rates cherished by borrowers and Congress will be a thing of the past. Consequently, servicing debt will become increasingly burdensome.
“If interest rates on federal debt were to revert to their levels from 1995,” warns Kevin Williamson in National Review, “we would face annual interest payments of $1.4 trillion on existing debt; this would mean that interest payments alone would consume 45 percent of federal tax revenue in 2015.”
Economic Profanity
It is evident that China’s economy is deflating, and Beijing’s attempts to stabilize the yuan are ultimately in vain. Such measures cannot remedy the underlying market distortions and misallocations caused by years of excessively cheap credit. The financial markets will eventually correct these misallocations, irrespective of government intervention.
This shift will have repercussions not just for China but for the United States and the global economy at large. As the second-largest economy by GDP and the largest when adjusted for purchasing power parity according to the International Monetary Fund, a deflationary trend in China signifies a broader decline in global economic activity.
This situation is vividly illustrated through the lens of industrial commodity prices. China’s debt-fueled growth spurred false demand, prompting mining firms to significantly increase production. Now that such demand has dwindled, prices have plunged; for example, copper prices have fallen nearly 50 percent over the past five years.
The fallout also brings secondary consequences, such as job losses, downsizing, and widespread bankruptcies. These are all forms of collateral damage stemming from the wealth exodus from emerging markets. In the U.S., interest rates may also experience upward pressure once the initial influx of capital from these markets subsides.
It’s essential to remember that the Federal Reserve has limited options. With interest rates already near zero, any further extreme measures would be akin to a Clydesdale horse relieving itself on asphalt—ineffective and crude, yet indicating a concerning future cycle ahead.
Sincerely,
MN Gordon
for Economic Prism
