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Why world jumps when China catches a cold

Someone asked me to explain in simple English what is happening with the Chinese and the global financial markets. Many articles default into financial jargon and assume everybody understands. This is hardly the case.

The problems were triggered by a Chinese decision to lower the value (devalue) of its currency against other currencies. This move was meant to make Chinese products abroad cheaper and thereby increase production at home. By so doing, Chinese workers would be guaranteed jobs.

If such an intervention is not made, economic growth declines (contracts) leading to massive layoffs and economic disruptions.

But still people ask, why do Chinese domestic issues impact the global markets? There are many reasons starting with the fact that China is the factory of the world. From the phone in your hand to your children’s toys, China manufactures for everybody.

Most corporations simply do the design of their products and sub-contract Chinese companies to produce them cheaply.

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It is also the source of raw materials for many emerging economies. Any disruption affects the financial statements of these companies across the world.

Since most of them are quoted in different stock markets, the impact is felt across the globe. Any economic decision-making by China that affects the performance, structure, and behaviour of the whole economy can therefore directly impact global corporates.

This is exactly what happened upon the devaluation of the Chinese Yuan currency. It gets even more complicated given the fact China, although a very powerful economy, keeps its exchange rate fixed. In other words, it is not determined by market forces.

As a result, many markets suspect that the People’s Bank of China artificially keeps the dollar strong (The People’s Bank of China has an estimated reserve of over $3 trillion to buy US currency and Treasury notes from the open market) to ensure the Yuan remains weak.

As I said earlier, a weak Yuan guarantees more exports especially to the US where China has a significant trade surplus.

The US has maintained that the Chinese Yuan is undervalued by between 20 and 40 per cent. Attempting to undervalue it further made the markets even more suspicious that all was not well with the Chinese economy.

Some economists argue that the manipulation of the Yuan undermines other developing countries’ competitiveness.

Goods and services from China become abnormally cheap to the extent of hurting other economies simply because other currencies cannot compete with the Yuan in the open market. Cheap goods from China also discourage domestic manufacturing in other countries.

It is also not healthy for the Chinese since undervaluing the currency is often the cause of inflation.

Also, Chinese people willing to buy goods, as they often do, from Germany and other countries cannot afford them because they are artificially expensive. But it sure does guarantee jobs for the Chinese worker.

By any account, China has done well over the past few decades, moving more than half a billion people out of poverty in less than 20 years.

World Bank data shows that between 1960 and 1980, the Chinese economy grew at an average of five per cent. By 2008, the annual growth rate stood at 14.2 per cent.

Although the growth rate see-sawed between nine and 12 per cent per annum, the average growth rate remained high at 10 per cent.

Experts estimate that China’s growth rate this year will decline to seven per cent which by any measure is a significant economic contraction and the reason why the markets are worried.

Investors, especially those who either have fully or partially financed their investment through some collateral, are facing an immediate risk where the brokers may be asking them to inject further cash to cover possible losses often referred to as margin calls.

Since this is an immediate crisis, some investors might be forced to sell off assets to cover the margins and as a result cause panic.

Such panic sales could flood the market and possibly force prices to fall drastically. Some stock exchanges might even temporarily close down to stall panic sales.

To correct the situation, China has taken the option of lowering interest rates. This action too is meant to lower the cost of credit such that businesses will borrow more and keep production at high levels and save the economy from contracting.

Although China cannot agree, it is decisions like this that validate suspicions that China is undergoing serious economic problems.

For now, however, the markets seem to be stabilising, but they need more positive economic information from China as the country tries to balance between the quest to become the leading economy in the world and keeping its markets abroad and friends as well.

The writer is an associate professor at University of Nairobi’s Business School.

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