Consider past global market issues, namely, Greece meltdown and US Federal Reserve procrastination over interest rate hike, all which held investors on edge for months. Topping the latest similar global concerns are oversupply crude oil market and weakening Chinese currency.
On the face of it, it seems an annual global market size of over US$1 trillion (RM4.4 trillion) oil demand based on US$30 per barrel prices should be a boon to China’s US$10 trillion gross domestic product (GDP) for 2015.
It is not that crude oil, as an industrial input, presents an issue to China’s voracious appetite of the commodity at low prices; the global economy, in general, and China, in particular, fear the onset of deflation retarding growth: a long period of collapsing crude oil prices contributes to such an outcome as in Japan’s long-running fight against stagflation.
China contributes a significant portion to global growth which benefits immensely from low crude oil prices. Typically, both crude oil prices and the yuan move independently but the world is about to witness a toxic relationship by their simultaneous drop in values. The early warning sign of such parallel market movements on the downside is depicted in two Chinese stock market selloffs within a period of less than six months.
Most will agree that 2015 did little to improve the global economy except waiting for two developments to happen: US central bank’s procrastination in hiking the first interest rate in a decade until a quarter-point rise announced on Dec 18 and China’s risky policy challenge to ride out a slowdown by massaging the yuan exchange rate – Chinese currency is denominated in the yuan.
Of the two, US’ rate hike was done with, but what remains a controlled yuan weakness onshore diverging from the free offshore rate seen in these market turmoil renews global risk.
China is known for setting the yuan exchange rate. In the absence of strong events overhanging the global market, generally, the market is made to believe like in the past 35 years of its growth history China will pull through with whatever is required in intervening the yuan exchange rate.
But the global economy has come to realise we live in a rather extraordinary time such as borrowing from the future to maintain the current lifestyle without inflation, mainly the result of benevolent central banks of the advanced Western economies in extending easy monetary policy by increasing money supply at near-zero interest rates since 2008.
It seemed not too long ago when the global economy was almost grounded by the financial crisis of 2008 and survived till today, mainly due to the boost of US$11 trillion cheap money spent by the world’s central banks since 2008 under so-called monetary policy of quantitative easing (QE).
The objective of QE is to stimulate investments and jobs eliminated by the last recession. That did not happen instantly as advanced economies struggled with sputtering growth. Cheap money went, instead, for financial investment, not to physical investment which is likely to grow much-needed manufacturing jobs.
Easy money does travel globally in search of higher returns with the chief beneficiaries being commodities and real estates. The crude market, which is the most-traded commodity globally, is characterised by a high-risk concoction of geopolitics, currency swings and macroeconomic fundamentals that generate trading volatility, attracts big fund investors.
The combination of an oversupply oil market and the early January 2016 flare-up of geopolitical tensions between two major oil producers, Saudi Arabia and Iran, added more bad news to an ongoing bear market after declining from a high US$140 in 2014 to US$33 per barrel at writing time.
The Organisation of Petroleum Exporting Countries’ decision to scrap production limits in late 2015 weighed heavily on investors to short crude oil on any price rally. The race to the bottom by oil producers for survival at the lowest production cost means low-cost producer Saudi Arabia (estimated at above US$10 per barrel) will cream off more market share and crude oil prices are poised to soften further.
Interestingly, the bearish oil market provides little boost to the present global economy while recovering from the last financial crisis. It is because of the greatest fear of deflation oozing out by a long duration of low oil prices, a major economic headwind straining growth encountered by Japan, the European Union and the US.
China, an emerging market, is no exception though, as the world’s largest importer of crude oil, it should benefit by some deflation from low crude oil prices. But low crude prices coincided inopportunely, with a slowing Chinese economy looking to shift course from manufacturing to services. That meant consuming less crude for manufacturing though import has risen in late 2015, due mainly to more like buying cheap oil for stockpiling purposes.
In turn, China, being also the world’s largest exporting nation, does export deflation in the form of cheaper goods shipped overseas, the result of lower crude input costs. The most unsettling for China is how to limit the dis-benefit of deflation from impacting negatively on projected GDP rate, in general, and the yuan exchange rate, in particular.
Obviously, Western central banks are perturbed by China’s unleashing of deflation to the world. Being the world’s second-largest economy, foreign central bank policymakers are worried over falling Chinese factory gate prices, driven initially by low crude input and translated into cheaper exports because of a depreciating yuan.
In September 2015, New Zealand central bank governor Graeme Wheeler expressed anxiety over yuan devaluation when announcing an interest rate cut. That concern was raised following People’s Bank of China’s sudden announcement of a 2% yuan depreciation owing to a new formula of aligning with a basket of currencies instead of pegging it to the US dollar after years of relatively appreciating and stable yuan.
Apparently, a parallel relationship of a downward slide of crude oil prices and a yuan depreciation had already emerged prior to the two China stock crashes – on Aug 24, 2015, (Shanghai Composite Index posted 8% drop) and Jan 5 to 7, 2015 (a 14% drop).
Unlike the US, which is now a producer of shale oil, allowing export after lifting an age-old ban and has been a leading global importer, China is simply a major global oil consumer. Viewed as a placid consumer and removed from the geopolitics of the oil-producing countries, in contrast, to the American active military involvement in the Middle East, the oversupply build-up of crude oil is beginning to cave in on China’s financial reforms.
It started with crude oil bearishness taking a dramatic turn in 2014 when it dropped by 40% from June (US$115 per barrel) to December (US$70 per barrel). Meanwhile, China, in a race to put some finishing touch of financial reforms for the eventual International Monetary Fund’s granting of special reserve currency status in November 2015, had increased the yuan trading band by 2% in March 2014 and later widened again to 3% in July 2015.
According to currency analysts, wider trading bands have little outright effect on currency movement. But not in the case of China. History reveals wider trading range leads to a weaker yuan, however, by no means this was not the issue during this stock turmoil.
As market fear built into China’s devaluation during this turbulent period, Shanghai stock market spun into the first selloff in August 2015 following months of rising stock prices since late 2014 . In early 2015, Shanghai Composite Index began an upwards trend soaring 151% originating in July 2014 to the peak on June 12, 2015. However, the opposite is happening to crude prices from June 2014 trading at US$115 to below US$50/barrel by August 2015, a drop of 56%.
Meanwhile, the strength of the yuan which hit a five-year high of US$6.05 against the dollar on Jan 6, 2014, weakened ever since in line with lower trending crude till the implosion of Shanghai’s first stock market on August 24, 2015. On that day yuan traded weaker at US$6.39 down by 5.6%. Somehow, market analysts hypothesised Chinese weakening currency move was more a sign of oil-deflationary forces working their ways into the broader market fund outflows amid a widening spread between the onshore and off-shore yuan rates.
Data suggested China registered the biggest annual drop of US$512 billion to US$3.3 trillion in its reserves for 2015, in part, because of the heavy cost paid for defending yuan depreciation.
The second Shanghai stock crash on the turn of new year 2016, revealed the same market panic of past August debacle. By then, crude traded down further to about US$34/barrel and yuan spike up to US$6.59 against the dollar, confirming further a convergence of what appeared to be a toxic crude/yuan pricing relationship. It was not China’s falling GDP rate, as market fears appeared to be, but the weakening yuan that upended global markets from Tokyo to New York.
If there is a lesson about Chinese stock sell-off, it is the relationship between crude oil price and the yuan in a slowing global economy or rather a collapsing oil market seals the fate of a weakening yuan. Since the bearish crude market has some way to go, it will be interesting to decipher Chinese policy on the future direction of the yuan, now that it has attained a special drawing right status by the IMF.
In conclusion, the US Fed’s low interest rate regime had fed through the global market after a long seven years, fuelling the crude market with easy money and caused a weak yuan at a watershed in Chinese economic shift. With two stock market crashes in less than six months, global money managers are cottoned on China, being the epicentre of the market rout, may be facing a difficult and uneasy slowdown in 2016.