The contagion from the yuan and from Chinese equities has laid low markets across the world, ensuring a gloomy start to the new year. Neither developed nor emerging markets have been spared-the MSCI World index, a barometer for developed markets, is down 6.09% in 2016, while the MSCI Emerging Markets index is down 6.81%.
US markets laughed off spectacular job increases in December and continued to merrily pummel the bulls. The Japanese yen continues to strengthen as risk aversion rises and carry trades unwind. The less said about oil and commodities the better. The Chinese contagion is now global.
The thought uppermost in the minds of investors is: how bad will be the infection from China?
The World Bank deserves a pat on the back for making its latest Global Economic Prospects report, out last week, all about spillovers-from China and from the other BRICS economies.
Here's the nub of it: "If, for example, BRICS growth persisted at its current weak levels (3.2% annualized) through 2017 instead of the currently projected pick-up, the rest of emerging market growth could slow by about 0.4 percentage point from the baseline forecast in 2016 and about 1 percentage point in 2017. The impact would be considerably larger if BRICS growth were to slide below current levels. For instance, if BRICS growth slowed by as much as the average forecast downgrade during 2010-14 (0.2%), growth in the rest of emerging markets and in frontier markets could fall 1-1.3 and 0.5-1.5 percentage points below the baseline forecasts in 2016-17, respectively. Growth in G7 countries would fall considerably less, by about 0.3-0.6 percentage point during 2016-17. Overall, global growth would decline by about 0.7-1.1 percentage points below the baseline forecasts in 2016-17."
There's also the risk of a domino effect from China. For example, the report says that India is comparatively less affected from risks emanating from China. That may be true, but the entire Asia-Pacific region will be hard hit because of trade and supply chain linkages.
Similarly, Australia and Brazil will be hurt because they will no longer be digging things out of the ground for China.
And the lower demand from all these regions for crude oil will affect West Asia.
Developed countries that have large sales to China, such as Germany and Japan, will be hit. The impact on India will, therefore, be not just its direct exposure to China but also its linkages with all these countries.
Of course, China has no monopoly on risks. The low oil prices have had a disastrous effect on oil exporting countries. And the markets still haven't priced in more than two US Fed rate hikes this year.
There are several channels through which contagion spreads. These include: 1) trade channels; 2) financial market channels; 3) through the impact on remittances and 4) confidence channels.
Low growth in emerging markets, when combined with financial tightening could result in Chinageddon-a Chinese Armageddon for the global economy-with the World Bank estimating that global growth would slow down even further from their baseline forecasts.
Recall also the effect that lower oil and commodity prices will have on companies in those sectors, which could spread to banks that have financed those companies.
The remittances from West Asia to countries such as India and Pakistan could be affected. Sovereign funds from oil exporting countries are likely to sell their holdings, driving markets down. And if that's not enough, there's also the currency risk from a strong US dollar and the depreciation of the renminbi, which could lead to currency wars.
This is, admittedly, a worst-case scenario. The growth in jobs suggests that the US economy is doing well, although the data is at odds with the other indicators such as the Purchasing Managers' Index, which indicates a slowdown in momentum and a gross domestic product (GDP) estimate from the Atlanta Fed of a mere 0.8% growth in the fourth quarter of 2015. Europe is seeing a recovery.
To be fair, the World Bank report also says, "a positive impulse from the US or other advanced economies tends to be associated with a one- to two-quarter initial increase in cyclical real GDP in India and the rest of South Asia."
And after desperately doing all it can all these years to prop up the markets, the US Fed is very unlikely to do anything that will rock them.
The unknown unknown is the confidence channel. Markets have been propped up in recent years primarily on faith in central bankers and policymakers. Anything that undermines that faith would, therefore, lead to markets cracking. For example, while everybody knows China is slowing, the consensus still thinks it will be an orderly transition from investment- and export-led to a consumption-led economy and the markets are full of faith that the all-powerful, all-insightful, all-wise Chinese Communist Party will rescue them. But belief in Xi Jinping's abilities could well prove to be as unfounded as trusting the wisdom of Kim Jong-Un of North Korea. After all, the introduction and the abrupt withdrawal of an ill-designed circuit-breaker in the stock markets, the faltering efforts to prop up stocks, the contradictory signals about the currency all indicate that as far as the markets are concerned, China's efforts have a tendency to degenerate quickly into farce. Nemesis has a tendency to follow hubris.
It is from this lack of confidence that the Indian markets may be most affected. The World Bank report says, "A sharp slowdown in a large BRICS economy could lead to s general reassessment of investor risk sentiment. This could trigger a plunge in prices of emerging market assets, currency depreciations, equity market drops and bond yield spikes across emerging markets". The "large BRICS economy" is an obvious euphemism for China.
In arrangement with HT Syndication | MINT
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