Global Markets Weekly – 21^st May 2007

Key Macro economic developments

• Barely a week goes by without a further illustration of the dramatic growth of the Chinese economy, whether it relates to developments actually in China or the consequences of this growth on economies elsewhere. The April fixed investment data, showing a more than 25% annual gain in expenditure, provided the latest indication of the sheer momentum behind China at present, aggravating concerns in turn of a possible overheating.
• Clearly, the mixture of growth at the current stage of China’s development would be expected to have a fairly substantial bias towards investment expenditure, given the rapid pace of industrialisation. But if the focus of this investment is misdirected, such expenditure may ultimately prove to be a deflationary force in the future, as the economy struggles to work-off excess capacity within certain industries. There are no real indications that any widespread misappropriation of investment is in fact occurring. But suspicions will nevertheless remain, particularly as alternative, financial market investment opportunities remain limited in China and pricing across the product/credit markets is not entirely market-determined.
• The Chinese authorities face a delicate balancing act in trying to reign in any ‘unproductive’ investment whilst maintaining confidence levels across the economy and still ensuring strong growth, particularly ahead of this year’s Party Conference and next summer’s Olympics. The volatility and uncertainty that followed the rumoured introduction of capital gains taxes on share dealing back in February, with Chinese equities falling by 7% in a single trading session, highlights the difficult nature of the task ahead.
• The financial markets expect further interest rate increases, lending restrictions and a continued appreciation of the renminbi exchange rate over the medium term. The People’s Bank of China actually moved last week to both increase interest rates and widen the bands within which the renminbi can fluctuate within a single day (from 0.3% either side of the central rate to 0.5%). Although this slight change in the management of the renminbi applies to both upward and downward movements, and looks to have been motivated more for political than immediate economic reasons, the move is in effect a further preparation for speeding up the pace of the currency’s appreciation.
• But other reforms aimed at a more micro level could also prove beneficial in helping the pace and structure of Chinese growth move to a more sustainable basis. Reducing subsidies on fuel and commodities, for instance, may provide a more accurate guide to the true costs of production and the potential profitability of investment. Attributing some cost to the environmental impact of economic activity may also result in a more efficient allocation of capital over the longer-term. Accounting for such factors, which economists often group under the broad banner of ‘externalities’, may do little to slow the economy in the near-term, but could well prove to be a useful policy option over the medium-term.

Key global market developments

• The 10-year Treasury yield hit a three-month high (4.77%), driven by the recent stronger data from the US and, possibly, some early speculation of what a stronger Chinese renminbi may mean for the US bond markets. The accumulation of huge foreign exchange reserves by the Chinese authorities, and the subsequent ‘recycling’ of these flows into the US Treasury market, is seen to be the direct consequence of the current exchange rate regime in China and any indication of reform here will certainly be of significance for long-term US interest rates.

Indices, Interest rates and Inflation

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