The Great Wall of Worry

News from China has been dominating headlines and increasing stock market volatility. Earlier this year, we witnessed their local stock market, represented by the Shanghai Stock Exchange Composite Index, increase by 59.7% in the first five and a half months of the year. That was on top of the 52.9% gain achieved in 2014. But, as we have learned from countless other skyrocketing markets, bubbles eventually pop. In China’s case, their stock market bubble started to deflate in June and has fallen -23.2% from the recent high (data source: Yahoo! Finance).

Stocks are not the only thing deflating in China. Last week the Chinese government let their currency start to devalue versus other currencies including the U.S. dollar. The key word in the sentence was “let.” Since 2005, China’s currency has been controlled by the government, some would argue, to benefit the Chinese economy.

As China’s role in the global market place has grown, its government desires to have a meaningful and influential voice in global economic policy. But, to have this greater voice, they have to play by the rules of the other major economies. When it comes to currency, the free market (not a government) needs to set the exchange rate for a currency. In fact, the International Monetary Fund told China this earlier this year when China started posturing to be considered a reserve currency. (A reserve currency helps nations more effectively trade with other nations because it helps reduce exchange rate costs.)

Last Monday, China took a step toward letting market forces determine its exchange rate. Over a three day span, China’s currency dropped by over 3% (source: Bloomberg). Their currency has appreciated over 30% versus the U.S. dollar since 2005, so a 3% move isn’t that significant in the overall trend. Yet, the fact that it occurred in a three-day period unnerved some investors.

Both the bursting Chinese stock market bubble and the devaluation of its currency has many questioning the strength of China’s economy. With China currently attempting to transition their economy from being the manufacturer of the world (one where they competed globally with low wages and low production costs) to one where they are more consumption based (like the U.S. and many other developed nations), lower growth was inevitable.

Yet China has been able to ride out the transition to consumption-based growth generally well until this year. Looking closely at the data raises concern about their recent progress. Specifically, the manufacturing sector in China is contracting according to data provider Markit. The July 2015 reading of the Purchasing Managers Index came in lower than forecasted at 47.8. This was the lowest it has been in two years (readings below 50 suggest contraction). Additionally, the employment market has been weakening and fixed-asset investment (e.g., property purchases) grew at its weakest pace since 2000.

Can embracing free markets help China? As believers in such markets, we think yes. Letting currency trade freely is a step in the right direction. Market forces have a wonderful way of evening everything out. The challenge is to let them do their work.

– written by Jonathan Scheid, CFA for Bellatore Financial (published August 17, 2015)