Russia looks exceedingly vulnerable to further dramatic swings in China’s financial markets and any weakening in Chinese demand for Russian energy.
China devalued its tightly controlled currency last week following a slump in trade, triggering the yuan's biggest one-day decline in a decade. Photo: AP
This week has been a brutal one already for global equity markets, but none have fared as badly as China’s. As of the end of trading on August 25, the Shanghai Composite Index had fallen to a level previously seen in December 2014, with no sign of a halt in its trajectory.
While the stock market plummet has been developing over the past month in waves, it was given new life on the heels of China’s three percent devaluation of its currency on August 11. Whether China’s devaluation has set in motion events similar to the last time China had such a devaluation (1994), or whether this is merely a correction from a particularly severe bubble, the severity of the decline is dangerous for a fragile global economy. At the very least, China’s fall back to earth will have serious ramifications for its neighbors and all emerging markets, including the Russian market.
The downward trajectory of the Chinese stock market
China’s economy has been moving at a breakneck pace almost continuously since the decentralization reforms of Deng Xiaoping took hold in 1978, with accelerating growth after the fall of Communism everywhere else in the world in 1991. Averaging just over 9 percent since 2005, China also appeared to bully its way through the global financial crisis with a fiscal stimulus package that consumed 20 percent of China’s GDP.
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However, China’s structural reforms have struggled to keep pace with this growth: Property rights are still routinely trampled, corruption is a feature (and not a flaw) of the system, and, most importantly, the financial sector has been at once both super-sized yet incredibly fragile.
Figure 1 – The Shanghai Stock Exchange in 2015
Source: Yahoo! Finance, based on Shanghai Stock Exchange data
This steep decline in the equity markets looks like a mild correction when looked at, Krugman-like, solely from the point of view of performance in 2015 (Figure 1). However, the run-up in 2015 was a stratospheric rise that can only be described as a bubble when seen in historical perspective, a rise that in fact was only surpassed by the bubble preceding the Global Financial Crisis in 2006-07 (Figure 2).
This previous bubble took nearly three years to inflate and then burst, with the inflation occurring from approximately October 2005 to October 2007. The current bubble in China was compressed in a much shorter time period, from trough to peak taking just under a year (June 2014 to June 2015), which may also account for the rapid crash since June of this year.
Figure 2 – Ten Years of the Shanghai Stock Exchange
Source: Yahoo! Finance, based on Shanghai Stock Exchange data
From the point of view of global markets, there are two major risks that come with China’s rapid equity market inflation and deflation. The first is that this summer’s turmoil also comes at a very fragile time for the global economy, with the Eurozone crisis not resolved and growth in the U.S. incredibly soft (and also volatile).
Just a few weeks ago, the world was entranced by the idea of “Grexit,” or Greece’s exit from the euro, and even though a bailout was just agreed to, Greece’s woes are far from over. Across the pond, the U.S. Federal Reserve has been hinting all summer that interest rates might begin their inevitable (and necessary) rise in the U.S. from their current bargain-basement levels.
But this appears to be suddenly off the table, as policymakers around the world are realizing that the global monetary bubble, so strong since the financial crisis, may require more inflation. Much as the currency wars of the 1930s penalized those who showed rectitude and remained on the gold standard, so, too, is today’s environment penalizing those who would have interest rates accurately reflect reality. China’s collapse would require, by this thinking, even more asset inflation to give the appearance of prosperity.
And it is this reality, that governments have been propping up the world’s economy with paper and promises for seven years, that is the most troubling aspect of the Chinese implosion. In China’s case, a sustained decline may reveal that the Emperor has no clothes, and that the Chinese government is out of tools to salvage the economy. As mentioned earlier, China was able to power through the global financial crisis via a vast redistribution of wealth from taxpayers to capital holders.
This time around, the government’s moves are proving less effective, with even draconian measures as prohibitions on stock sales and allocating huge amounts of government monies to purchase stocks not having the desired effect. This does not mean that the government has given up, as on August 25 the Chinese Central Bank cut its policy interest rate by 0.25 points and lowered reserve requirements, in an attempt to re-inflate the stock market. But while this move heartened the developed economies in Europe and the U.S., it is less likely to help the emerging markets that already are feeling China’s slowdown.
China’s impact on emerging markets
Indeed, the effects of China’s currency movements and its concurrent plummet in the stock market have already washed over its neighbors. Kazakhstan’s tenge was unleashed from its fetters last week in a move to a floating exchange rate, immediately losing 26.2 percent of its value.
While the move from the Kazakh Central Bank was a correct one, as it brings Kazakhstan a shift to an inflation-targeting regime instead of obsessing about the currency, the short-term damage may be immense. In particular, the volatility issuing forth from China has also struck global commodity markets, and Kazakh dependence on oil revenues is a major source of worry for the landlocked nation.
Similarly, Kazakhstan’s partner in the Eurasian Economic Union, Russia, is exceedingly vulnerable to China’s fluctuations. In the wake of sanctions after the Russian invasion of Ukraine, Putin openly pivoted towards China as a counterbalance to what he perceives as the monolithic West. While China is more than willing to discard Russia when it suits China, the fact that China is on the verge of a meltdown does not bode well for Russia free-riding off of China in the short-term (nor, indeed, does it say much for Russian President Vladimir Putin’s prognostication abilities).
Even if Putin had not been actively trying to bring Russia closer to its neighbor, the country was already hurting from its own internal weakness and external adventurism: The ruble, hitting new lows for 2015 against the dollar and euro in the wake of China’s Black Monday, was already on the road to becoming rubble due to declining oil prices. With China’s woes dragging oil lower, the Kremlin has to contemplate what life will be like in a world of $40 oil.
In reality, Russia will be incredibly hard-pressed to keep the same state-led development model it has been following for years, as mega-projects will suddenly become too dear for the government to finance. At the same time, Moscow’s increasing penchant for military intervention will also be a victim of the faltering economy, as one can only acquire so many economic basket cases (Crimea, Abkhazia, Transnistria) before the cost becomes far too high.
Across other emerging markets, the outlook also remains gloomy, as even the largest economies in this group have been on a downward spiral for some time. In fact, the BRICS (Brazil, Russia, India, China and South Africa) group of countries, once touted as possessing some mystical alternative to Western capitalism, has been the hardest hit: Apart from China and Russia, Brazil is in a recession that threatens to get worse due to an incipient political crisis, while South Africa’s GDP contracted in the second quarter at an annualized rate of 1.3 percent.
Of this grouping, only India, which has actually undergone some liberalization of its economy, continues to grow, projected at 7.5 percent this year by the International Monetary Fund (IMF). In fact, India might be the country to gain from China’s collapse, as India’s ravenous appetite for Chinese capital goods will be satisfied at a lower cost.
What lessons can Russia learn from this crisis?
India points the way to a crucial lesson for Kazakhstan and Russia, and indeed, for all emerging markets. Stronger economies weather financial volatility better than weaker ones, so the groundwork that needed to be put in place in Moscow and Astana needed to be there two years ago, not today.
Both Russia and Kazakhstan have surprisingly been forward-thinking in their monetary policies, with the shift to inflation targeting a welcome and needed change. Unfortunately, the move towards exchange rate flexibility at this juncture, combined with the structural flaws still inherent in both economies and China’s tumble, will likely mean that things are going to get much worse before they get better.
The descending dragon will not go quietly, and risks scorching everything nearby on its way down. The only hope is that the lessons of this crisis do not go unheeded in Moscow, to better prepare the economy for the next one.
The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.