Fed ties itself to China’s mast: James Saft

September 17, 2015

Sept 17 (Reuters) – Let’s not kid anyone: when the Federal
Reserve speaks of “global economic and financial developments”
in justifying delaying an interest rate rise, they are talking
about China.

That implies a long wait, as China is engaged in a needed
but dangerous multi-year effort to transform itself into a
consumer-based economy. It also ties Fed policy to the decisions
of Chinese policy-makers, a gang who not only can’t shoot
straight but whose idea of a market intervention involves a
certain unattractive raw forcefulness.

Very little of importance changed in the statement released
by the Federal Open Market Committee, other than one line:

“Recent global economic and financial developments may
restrain economic activity somewhat and are likely to put
further downward pressure on inflation in the near term,” the
statement said.

Fed chair Janet Yellen expanded on this at the press
conference, drawing an explicit line between the decision and
developments in China.

“We focused particularly on China and emerging markets,”
Yellen said.

“We’ve long expected to see some slowing in China as they
rebalanced their economy.”

The issue, according to Yellen, is “whether or not there
might be a risk of a more abrupt slowdown” in China than
consensus had expected. She also mentioned, in an understated
way, questions over Chinese policy-makers’ “deftness.”

“Developments we saw in financial markets in August in part
reflected concerns there were downside risks to Chinese economic
performance,” she said.

Let’s walk through this slowly.

First off, yes, there are concerns about other emerging
markets, notably Brazil, whose currency is down sharply and
which is now a full-fledged junk credit. Yet while Brazil, and
many other emerging market countries, are all unhappy now in
their own particular ways, the common denominators are two:
falling demand from China for raw materials and falling capital
flows from abroad on the expectation of rising U.S. interest
rates.

So the Fed is worried about emerging markets because: China
and the Fed.

This brings us back to China and the very real risks of
putting it so close to the center of the Fed’s policy-making
matrix.

China is going to be suffering transitional problems for a
long time. The process of switching from over-investment to
consumption is a very long one, upsetting the debt-reliant model
China has used since the financial crisis.

As for Chinese financial markets, they are a volatile mix of
fairground speculation and show trial, not the sort of process a
sensible central bank wants to find itself attendant upon.

IMPORTANT BUT OPAQUE

This both implies a potentially long delay in raising U.S.
interest rates – it will be years until the transition is stable
– and a heck of a lot of uncertainty. Given the opacity of
Chinese data and volatility of its markets, investors are really
going to struggle to understand how this interacts with Fed
decision-making.

It is impossible to gainsay China’s importance to the global
economy, and in turn to the main legs of the Fed’s mandate:
inflation and employment. Clearly if the Fed thought there was a
decent-sized risk of a global recession starting in China and
radiating out, then this decision is a good deal easier to
defend.

That’s certainly possible but, significantly, Yellen and the
Fed made mention not just of China’s economy but of developments
in financial markets.

Here is where the decision by the Fed to delay, or wait,
seems unwise and inconsistent.

Did the Fed see the sky-rocketing of Chinese mainland stocks
– with a tripling of the market capitalization of the Shenzen
and Shanghai composite indices in the year to June – as a reason
to tighten? Well if they did, they certainly didn’t mention it.

Remember that this rally was characterized by leverage and
by the sucking in of unsophisticated investors, many without a
grade school education.

So while the spectacle of Chinese stocks first rising by the
GDP of Japan and then falling, in only 22 days, by the GDP of
Britain is instructive, it is a hard thing around which to build
sensible policy. (here)

And as for Chinese policy-makers’ “deftness,” I share Chair
Yellen’s concern. China’s frantic efforts to reverse the
sell-off have been heavy-handed, probably counterproductive and
left us with Chinese financial markets which contain even less
information than previously. That’s before we get to the
ugliness of televising “confessions” of financial journalists.

Perhaps the Federal Reserve is better than the rest of us at
looking through this and seeing the underlying reality of
China’s financial system.

Perhaps not.

Best-case scenario: the Fed was spooked and will go in
October.

If they mean what they say about China we may have a long
and uncertain wait.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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