The lunar new year is celebrated throughout Asia, but many Westerners refer to the occasion as “Chinese New Year.” That alternative moniker may be justified, given China’s size relative to other countries in the region.
The new lunar year doesn’t begin for another three weeks, but it can’t come soon enough for China and its Asian neighbors. And that’s not just because of the celebrations and family reunions that take place but also because the Eastern world could use a fresh beginning after a very challenging start to 2016. Here are some reflections on what’s been going on.
- Chinese policymakers have yet to master the art of communicating effectively with global markets. To be fair, they are relatively new at this, but their inexperience has proven costly.
For the second time in eight months, the renminbi (RMB) began to drift from the tight window that typically bounds its movement. As was the case last summer, Chinese officials offered no context, leaving market participants wondering what motivated the change and how far the devaluation might go. An aggressive move could be very damaging to China’s neighbors, initiating a battle for business that rarely leaves a clear winner.
Adding to the intrigue was the gap between currency trading within and outside of China. “Offshore” trading, which had not been controlled as tightly, found the RMB weakening even further. This suggested that speculators were betting against the RMB.
After several very nervous days, the People’s Bank of China restored order. A large intervention in the offshore markets closed the gap in valuation and punished speculators. And the “onshore” depreciation was belatedly explained as an attempt to tie the RMB’s value to a basket of currencies and not just the U.S. dollar. That provided a modest measure of reassurance.
In the absence of official guidance, rumors form and travel fast. Re-centering conditions can be expensive under those circumstances; while still ample, China’s official reserves have dwindled. Better to steer market sentiment ahead of time and reduce the cost of mystery.
- China is still not at all comfortable allowing its markets to seek equilibrium freely. At the start of January, China implemented a new set of circuit breakers aimed at stabilizing equity markets. Unfortunately, the new policy had the opposite effect.
Sellers crowded into the opening moments of each day’s trading, in the hope of getting orders filled before limits were reached. Share prices hit their lower boundary quickly and closed trading for the day, building a perception that fair value lay far in the distance. The circuit breakers were quickly removed, in favor of the more-traditional strategies like directed purchases from the large Chinese banks. In the long run, such measures may not be sustainable.
China has expressed an aspiration for more market-based influences on its economy and less central management. But the Central Committee had a heavy hand in creating the bubble in Chinese equity prices, using expanded margin lending to promote more-democratic share ownership. Now that equities are correcting, that same heavy hand is being liberally applied to avoid a crash.
- Market events surrounding Chinese equities and the Chinese currency have led investors to wonder about the health of the underlying economy and the ability of policymakers to address it. This is not a new concern, but recent volatility exacerbated it.
China is attempting a very large and very delicate transition from heavy manufacturing to services. Unlike other nations that evolved in this manner, the Chinese are seeking to achieve their goals without suffering much of an interruption in economic growth. They need steady progress to sustain social stability, and they need to continue creating employment for those resettling from rural to urban settings.
Assessing the progress of the Chinese program is challenging. The best of their economic data is the subject of some skepticism, and services are even more difficult to account for than heavy industry. The lack of transparency – the subject of light humor when China was prospering – has become a much more serious concern.
- China’s influence on world markets goes far beyond fundamental linkages. U.S. exports to China account for just 1% of U.S. gross domestic product, but events in China have a pronounced impact on global investor sentiment.
As challenging news moves west through the trading day, risk aversion rises. Differences among asset classes and geographies are occasionally overlooked in the rush to the door. It can take some time for cooler heads to prevail.
A poor outcome in China would produce more hardship for its vendors, which include a series of emerging markets whose finances are not as solid. If dominoes began to fall in the region, the accumulated damage to global growth would be difficult to overcome.
Whether through fiat or the application of its war chest, China has the ability to steer its markets to desired levels. This may not serve the goal of market-based reforms, but it may calm things down for a while. Eventually, the Chinese will have to demonstrate that their markets are strong enough to withstand the daily scrutiny of investors. Until then, whispers about inflated asset values and economic prospects will get louder.
The lunar new year is traditionally accompanied by a horoscope for the months ahead. The outlook presently calls for significant financial events and a strong possibility of good fortune. We should all hope that the stars realign soon and favorable conditions return.
The Transmission of Oil Prices to Inflation
Crude oil is trading around $30 a barrel, down from a peak of nearly $62 in the middle of last year. It is well known that oil price changes are passed through to overall inflation. But it is not as clear how much is actually passed through to broad price measures and how much lag that transmission involves. These are important issues for central bankers as they assess inflation risks and design appropriate monetary policy.
The energy price index, a sub-component of the Consumer Price Index (CPI), accounts for about 4% of the index. It includes prices of both energy commodities (gasoline and fuel oil) and energy services (electricity and natural gas). Movements in crude oil prices directly affect the energy commodities component and indirectly influence a range of prices of goods and services that use crude oil and its byproducts.
There are other aspects to note. For example, the price of gasoline includes refinery costs, taxes, and marketing and distribution costs in addition to the price of crude oil. This indicates there is not necessarily a one-to-one relationship between crude oil and gasoline price changes.
The link between crude oil prices and inflation is complex, and estimates of the impact are highly variable. So while changes in the price of oil carry significant weight in perceptions of inflation, the month-to-month change in crude oil quotes does not have a terribly substantial impact on the CPI.
A large part of existing research focuses on the experience of a rising oil price environment and inflation. One study covering 19 industrialized countries for the period 1970 to 2006 indicates that, on average, in the short run, a 100% increase in oil price translates into a 0.5% increase in inflation one quarter later.
Falling oil prices in an expansionary phase of a business cycle are relevant to understand the current experience in the United States. Research at the Federal Reserve Bank of St. Louis indicates there have been five episodes of falling energy prices in non-recessionary periods in the United States during 1985-2013. Oil prices fell more than 10% during these occurrences, and the median duration of declines was six months. On average, inflation dropped 1.1 percentage points from the peak to trough.
Fast-forwarding to the present time, oil prices peaked at $105.80 per barrel in June 2014 (monthly average) and dropped each month until January 2015 ($47.52). The personal consumption expenditure (PCE) price index and the core measure, which excludes food and energy, fell roughly 0.9 percentage points and 0.2 percentage points, respectively, during this period. This is entirely consistent with historical experience and expectations.
Oil prices recovered from February to June of 2015 but resumed a downward trend for the most part thereafter. Monthly average oil prices plunged nearly 29% between June and November 2015. Based on history, inflation measures should have posted a decline during this period, but the year-to-year change in the PCE price index moved up slightly during the six months ended November 2015.
Crude oil prices have dropped about $10 per barrel, or 25%, since the beginning of December. This will surely affect upcoming inflation releases, but pinpointing the magnitude and timing of the reaction is challenging. Those following the path of the price level, including the world’s central banks, will have to sharpen their pencils.
Trading Curbs in Theory and Practice
Circuit breakers are designed to enhance stability in financial markets. China instituted trading restrictions as markets opened in 2016, following the harrowing experience of last summer when equity prices fell sharply. Unfortunately, the new circuit breakers had a very short life in China – a sum total of four days. The experiment left Chinese authorities with another challenge.
Circuit breakers are tools to address extraordinary circumstances when equity prices plunge to the extent that credit and liquidity evaporate and there is a significant potential for panic-driven selling. As much as a circuit breaker prevents the establishment of an equilibrium price, the purpose is to let financial markets calm down and allow market participants to pause and reassess information.
Supporters think trading curbs will prevent an escalation of volatility. Critics argue that circuit breakers will intensify price movements toward pre-announced limits and enhance uncertainty. Experience indicates that trading curbs should be designed with care to ensure an orderly functioning of markets.
The Chinese circuit breakers had 5% and 7% price declines as thresholds. Markets pause if the former prevails but shut down if the latter is hit. On January 7, both these marks were matched within a span of 29 minutes, which led to a trading suspension.
In a mature market such as the United States, circuit breakers have three levels. Equity markets pause for 15 minutes at 7% and 13% market declines from the previous day’s close, while a complete shutdown follows if equity prices drop 20%. The design of circuit breaker points in the United States has been successful.
The key takeaway is that circuit breakers must be set such that they are not activated frequently. Declines of 5% and 7% are frequent in China, meaning that circuit breakers have failed to achieve the safety objective they were supposed to ensure. Trading curbs may eventually be revived in China but only after extensive reflection.
(c) Northern Trust