Will the next recession be made in China?

How much we should worry about China has a lot to do with the definition of “we.” Most at risk are countries such as Turkey and South Africa that have heavy debt denominated in foreign currencies like the dollar, persistent inflation, and economies prone to trade deficits. When investors lose confidence in emerging markets, countries like these are always the first to suffer. Although less connected to China, Europe is at some risk, because its economy is barely growing, making it vulnerable to even a smallish shock. Asian nations such as South Korea and Singapore that sell a lot to China have obvious exposure, but they’ve amassed huge foreign reserves that protect them against speculation. They can cut interest rates to stimulate growth and counteract the drag from China without concern that investors will trash their currencies.

The turmoil has parallels with the 1997 Asian meltdown, including expectations of a Fed rate hike.

With its huge domestic market, America is always more insulated than other nations from the ups and downs of global trade. Exports to China amount to only 1 percent of its gross domestic product. And crude oil at about $40 a barrel — thanks in part to weakening Chinese demand — will lower the price of gasoline, giving U.S. consumers more money to pay down debt and eventually increase spending on other things.

It helps that the U.S. economy was on a slow but steady growth path to begin with, adding more than 200,000 jobs a month on average. New-home sales rose better than 5 percent in July, the most this year.

Equipment orders in July exceeded expectations. Auto sales have rebounded to their highest level since before the financial crisis. Consumer and corporate balance sheets are in excellent condition.

The scenario that gets veteran investors nervous is a repeat of the Asian Contagion of 1997 and ’98. Then as now, the Federal Reserve was poised to raise interest rates, oil prices were falling, and investors were losing confidence in certain emerging markets that had gone on a debt-fueled investment binge.

Deflation loomed, and money was flowing out of emerging markets at an alarming pace. Fed Chairman Alan Greenspan worried about how long the U.S. could remain an “oasis of prosperity.”

The U.S. played a role in causing the Asian Contagion, because investors withdrew money from emerging markets and put it in the U.S. to take advantage of anticipated interest rate increases. Likewise today, the Fed is preparing to raise short-term interest rates off the floor of near-zero, where they’ve been napping since the end of 2008. Higher rates in the U.S. will suck in money from around the world.

That, in turn, could further drive up borrowing costs in vulnerable countries such as Brazil, which the money is leaving. It’s the fear of this outcome that has investors suddenly obsessing over declines in obscure currencies like the Vietnamese dong and the Kazakhstani tenge.

The difference between now and then is that a lot of developing nations and global markets have braced themselves against the risks of a currency crisis, making a full-scale Asian Contagion unlikely. Morgan Stanley economists Manoj Pradhan and Patryk Drozdzik in London told clients on Aug. 24: “In a nutshell, no one can or should rule out a crisis, but we believe that the risk has fallen from a few years ago.”

The U.S. has even less reason to worry about contagion from Asia, since it wasn’t harmed by the original episode, says David Rosenberg, chief economist and strategist at Gluskin Sheff, a Toronto-based wealth manager. Over the period of the last crisis, he says, the Fed cut rates instead of raising them, stock prices rose, unemployment fell, and economic growth averaged more than 4 percent a year.

Still, the August selloff is bound to get the attention of Fed Chair Janet Yellen and her colleagues when the Federal Open Market Committee meets on Sept. 16 and 17 to decide whether to raise rates. Because of the latest turmoil, markets are betting the Fed will wait until at least December. That’s probably right: The Fed has cited “international developments” as a factor to watch in each meeting since January, says Lindsey Piegza, chief economist of Stifel Nicolaus, a Chicago-based investment firm. For the Fed, the biggest concern is that in a turbulent world, the dollar will become even more of a haven, driving up the exchange rate and making U.S. goods and services less competitive in global markets. Although the dollar has sagged recently against the euro and yen, it rose 13 percent this year through July, according to the Fed’s index of a broad set of trading partners’ currencies adjusted for inflation.
 
Financial markets depend on good information. When it’s lacking, investors flail. They assume the best when they’re bullish and the worst when fear gets the best of them. That helps explain the eruption over China, a nation that remains opaque despite having the world’s second-biggest economy.

Facts as basic as its GDP are hard to pin down: Officially it grew at 7 percent in the first and second quarters — suspiciously, precisely the rate Li predicted for 2015. Some outsiders put growth at closer to 5 percent based on data such as electricity consumption and rail cargo. The official unemployment rate is even less plausible. Despite all the changes China’s gone through, it hasn’t left a narrow range of 4 percent to 4.3 percent since late 2002.

Financial markets don’t mesh well with command-and-control economies, either. Traders react instantly to new information, constantly updating prices on the latest intel. Viewed up close, the process of adjustment can look choppy to China’s leaders. They try to keep a lid on volatility the opposite way—by fixing prices and rates—but all they manage to do is bottle it for a time. “The first marker of a fragile state is a concentrated decision-making system,” wrote Nassim Nicholas Taleb and Gregory Treverton in the January-February issue of Foreign Affairs.

China still has a lot of strengths, including plenty more room to cut interest rates if needed and a war chest of about $3.6 trillion in foreign exchange. (Although it’s spending dollars fast to support the yuan.)

What it lacks for the first time in awhile are trusting investors. Some are angry enough to have taken matters into their own hands. On Aug. 22 a group of investors seized the head of the Fanya Metal Exchange, threw him into a car, and drove him to a Shanghai police station, alleging that Fanya had stopped making payments on its heavily advertised financial products.

These are strange times. Barack Obama has spent his entire presidency with short-term interest rates of essentially zero percent. The transition back to normal, when it happens, might be wrenching at home and abroad.

For the U.S., the nightmare scenario is less financial than political; no one wants a China whose leaders try to cover up economic woes by stirring patriotic fervor with confrontations in, say, the South China Sea or East China Sea. (One Putin is enough, thanks.) An embarrassed leadership could be even harder to deal with than a boastful one. Bashing China is a popular American sport, especially on the campaign trail, but gloating over the made-in-China meltdown is an antiquated response. When China sneezes, the world just might catch a cold.

See also:

Three ways Yellen could better speak her mind on the next rate hike

Chinese delgation looks for LTC insight in Washington

Fischer says temporary inflation factors still a Fed concern