Greece, China and the middle-income trap

For the Greeks, the most positive aspect of the referendum was its clear-cut outcome. For markets, the same can also be said.

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That’s not to second guess some of the far more insightful analysis and forecasting coming out of Europe about this dire situation, it’s simply to state the obvious about the amoral nature of markets. Markets don’t make moral judgements only (economic) value ones.

" The Greek tragedy reinforces we still live on an economic planet whose axis is the north Atlantic."
Andrew Cornell, Managing Editor

Even the shock resignation of Greece’s hardline – politically – finance minister Yanis Varoufakis in the wake of the result saw markets react by 'pricing in' the possibility of concessions to the European creditors.

Yet the Greek tragedy reinforces we still live on an economic planet whose axis is the north Atlantic. Despite all the attention on Greece, a relatively miniscule economy, the impact on regional and global growth of what is transpiring in China is far more fundamental. Yet lagging in the headline stakes.

Markets were of course roiled in the wake of the Greek result with renewed speculation around an exit from the Euro – the “Grexit”.

Yet the various volatility indices watched to gauge the degree to which global investors are betting against stability peaked last week when polling suggested the referendum would be too close to call.

Again though it seems extraordinary volatility indices appear more responsive to Greek gyrations than China – although that would also reflect the far greater confidence markets have in the Chinese executive to manage their economy than they do in the unpredictable Greek leaders.

In many ways, Greece doesn’t matter economically to the European Union. Indeed, it is a bit of a sea anchor. The Financial Times published a fascinating infographic showing losing Greece would only see EU population fall just over 3 per cent – and the average age would decline by nearly three years, demographically positive for economists.

Gross domestic product per capita would actually rise 1.5 per cent and total economic output would decline less than 2 per cent.

The problem with Greece is uncertainty. It may be small but there are real fears of contagion. Will there be less support for other 'peripheral' European economies like Portugal? Could it be the start of the unravelling of the Euro?

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Caption: ATHENS, GREECE - 2015/07/03: A demonstration in Syntagma square in support of a 'NO' vote on the 5th of July referendum that will decide the fate of the negotiations between the Greek government and its creditors about the Greek debt. (Photo by George Panagakis/Pacific Press/LightRocket via Getty Images).

Yet even then markets look for price signals. For example, betting on when the US Federal Reserve would start to raise interest rates priced this critical shift as now being delayed.

Some of the flow-on impact to Asia is predictable: the Japanese yen, for example, has long been considered a safe haven currency.

Already this year, European banks have been piling into Japanese funding via so-called 'samurai bonds', raising $US6.8 billion according to Dealogic data with 9 of the 10 biggest deals in the last couple of months as Greece heated up and European funding markets, including German bunds, became excessively volatile.

Yet it is extraordinary what is happening in Greece, dramatic as it is, can trump the truly seismic events occurring in China, the world’s most powerful economy.

While many believe Chinese equity markets, particularly Shanghai and some of the smaller ones, are at the casino-stage of evolution and massive price rises and falls are to be expected, the Chinese authorities have still been acting.

They undertook a massive buying campaign of local stocks via a stabilisation fund to put a floor under the recent 30 per cent plunge on equity markets. They have also suspended all new initial public offerings (IPOs) to preserve liquidity.

The Wall Street Journal reported the State Council, the People’s Bank of China and various financial regulatory agencies held a meeting on Saturday in an effort to tackle market uncertainty. Stocks had continued to fall despite the PBoC Reserve Ratio cut, a reduction in market trading fees and an easing of restrictions on margin lending.

But as Triple T consulting analyst Sean Keane said in his note for Credit Suisse, “the new actions announced over the weekend appeared initially to have worked with the Shanghai index witnessing an opening bounce of 7.8 per cent”.

“Unfortunately the market mood remained heavy however and the gains were quickly halved as Greek sentiment affected the market mood. By 10am (Monday New Zealand time) the bounce was back to a rather disappointing gain of 2.7 per cent and towards the close the market was back to virtually flat on the day.”

It is remarkable events in Greece can overwhelm official efforts in China. It may have been dismissed as a reaction spike except the Chinese authorities have been struggling to buoy Chinese markets for some time now.

For the region, and the world, this is very significant, not least because of China’s track record in managing change in financial markets on an enormous scale. While people may disagree with China’s political system, few with experience would question the technical competence of its leaders.

The world may be worried about potential contagion from Greece but it seems to not have the same attention span for the volatility of the economic transition China is undergoing.

In the East Asia Forum, the Australian National University and Crawford School’s Peter Drysdale argues one huge driver of the “One Belt, One Road” policy to shift the Chinese economy towards consumption is the ongoing need to address massive overcapacity in heavy industries and inefficient exporters.

Drysdale argues China is now at a point of development where the so-called “middle-income trap” is most dangerous, thwarting further evolution into a high income, more services oriented economy.

Yet in the EAF newsletter this week, economist Ross Garnaut cautions China's slowing growth trajectory masks weaknesses in the structure of transition to the 'new normal' – not just some stumbles.

“China's new model of economic growth — now described by the Chinese leadership as the 'new normal' — embodies structural change at an immense scale and pace” Garnaut says. "But China has made little progress towards the macroeconomic structural changes that are necessary for the new model's success. Most of this lies ahead.”

Critically, he argues lower growth rates since 2011 seem to reflect the effects of structural problems inherent in the old model of growth more than the effects of transition to the new model.

“From 2011 China has been more reliant on increases in the capital stock than any point since 1978, while growth in total factor productivity has — as in many countries — had a declining impact on output since 2008,” Garnaut says.

Neither Drysdale or Garnaut are arguing China’s policy ambitions are wrong, indeed the opposite. But what they draw attention to is the complexity and enormity of the challenge – and how much it matters to the rest of the world.

Greece doesn’t matter to this story. Indeed, even the European project is less of a threat over a longer time frame than China failing to make the transition through the middle income trap. Greece, of course, may now be on a trajectory to fall backwards towards a developing country.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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