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FOREIGN EXCHANGE

Hurrah, the recession is over – but will China crack?

I confess to feeling a bit depressed this week. Like many of my old muckers in the market, I’m fed up of the narrow ranges that suggest we’ve already sailed into the summer doldrums. My mood has not been helped by an irrational fear that the global economic downturn is far from over, despite what numerous politicians and central bankers keep claiming.

In the UK, unemployment has risen to 7.6%, the highest level since January 1997. Interestingly enough, perhaps, that was the same year that ‘new’ Labour, led by Tony Blair, took office. Plus ça change, plus c’est la même chose.

Anyway, my wife has told me to stop moaning and I have taken her advice.

I was absolutely delighted to receive some research from Bank of America/Merrill Lynch declaring that the recession is over.

Published by the bank’s research investment committee, the report says: “The global recovery is likely to be slow and require sustained policy help. But an inflection point in the global economy should encourage investors to rebalance their portfolios to reduce cash and to look for opportunities to increase equity exposure while staying with high quality bonds.”

It adds: “The 7% gain in global equities over the first half of 2009 masked an epic ride for equities and most other asset classes. The most severe banking crisis since the 1930s, a meltdown in economic activity and an aggressive financial, monetary and fiscal policy response all characterized the first quarter of the year. The end of an extreme inventory de-stocking and trade cycle, economic ‘green shoots’, most notably in China, and a recovery in asset prices marked the second quarter.”

Of course, a great many uncertainties remain, which is no doubt why short-termism seems to be the dominant theme in FX at the moment. BofA/Merrill believes that if its analysis proves correct then, “outperforming the dollar over the next 12 months will be the Bric currencies, specifically Brazil, China and India, against which the dollar should drop 10%.”

If this proves correct, it will be interesting to see how China reacts. As BofA/Merrill points out, there has been a good deal of sabre-rattling from the Bric bloc about the need for an alternative reserve currency. They can engage in histrionics but they ignore the obvious solution of fully floating their currencies and making them tradable and easier to settle. Meanwhile, China’s dollar reserves have started to grow at a rapid rate once more, breaking through the $2 trillion barrier in April. According to research from Standard Chartered: “Hot money may be back, encouraged by super-loose credit. But the headline is clear, China’s FX reserves are rising again, and unexplained inflows are a factor again.”

BNP Paribas is perturbed by this. “We are also getting concerned with regards the pace of growth with the Chinese money supply. Although this is currently providing some support to asset markets and the commodity currencies, medium-term implications are likely to be negative, with an increasing risk that China will now start to withdraw liquidity. Indeed, Chinese authorities have expressed their unease that banks might have allocated credit into segments creating substantial write-downs down the road. There is also evidence that a significant amount of the liquidity that has been pumped into the system has worked its way into more speculative investment (commodity trading) rather than structural investment, raising concerns.”

But BNP warns: “We expect China’s liquidity conditions to become less expansionary, which might be universally bearish for commodities and commodity currencies.”

For today I’m optimistic. But who knows how long that will last?

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