Why do world markets dance to the Yuan’s tune?

As the Chinese economy threatened to slow down and the Yuan is devalued, the entire world markets felt the impact. From the US to Europe to Japan to Asia, Latin America every market virtually cracked under the pressure of Chinese correction. Of course, two lower circuits in a single week indicate a problem that is much larger than is currently evident. People are not worried only about the fall in China’s growth but also the lack of transparency. While China claims to be growing at about 7%, unofficial estimates put China’s growth at closer to 5%. That will be a major loss of growth momentum for world markets. But first we need to understand why China is so very critical to the world economy and what makes the world dance to the tune of the Yuan?

It has produced most of global GDP growth…

In the last few years, nearly 50% of world GDP growth has been created by China. The globe with a GDP of $70 trillion has been growing at 3% per year adding nearly $2 trillion to world GDP each year. China with a $10 trillion economy has been growing at 10% for many years adding nearly $1 trillion to the world economic GDP. Effectively, China has been adding 50% of world GDP growth. Even the US only contributes about 28% to the annual GDP growth. That underscores the importance of China. It is only because of China growth fears that the IMF and the World Bank have been consistently downgrading the global growth rate this year.

World’s biggest consumer of commodities…

China is the world’s largest importer of crude oil and every other conceivable mineral, metal and alloy. That makes China critical as far as the economies of scores of other economies are concerned. A wide array of economies ranging from Australia, China, Brazil, Argentina, Middle East, Africa, Indonesia and Singapore are highly dependent on China for spurring their growth. A slowdown in China means that nearly 70% of the world economies get affected either directly or indirectly. That is surely a matter of concern.

There is a serious currency angle to it…

Of course, we cannot forget the currency angle. As China slows, a large number of commodity dependent countries will see depreciation in their currencies. We have seen that in case of Brazil, Argentina, Malaysia, and Indonesia as well as advanced economies like Canada and Australia. China has already started attempts to weaken the Yuan to push up exports. It is highly likely that its decision to weaken the Yuan may lead to a full-fledged currency war due to the strong externalities that the Yuan possesses. An all-out currency war has always been detrimental to most economies around the world. And that also includes the threat of dumping of cheaper products in economies like India which have large markets and uncompetitive domestic players.

China holds the largest chunk of US treasuries…

Currently China holds US treasuries to the tune of $1.25 trillion and is the single largest sovereign holder of US treasuries. It has almost become the largest lender to the US and has been funding its borrowing program. Over the last one year, China has expended nearly $512 billion of its reserves in 2015 to support the Yuan value. It is very likely that further weakness in the Chinese economy may force China to dump US treasuries in the market and use the cash to prop up the Yuan against the dollar. That may have long term negative implications for US debt and international interest rates. That is a major worry for the US Fed and for the global debt markets.

World’s biggest consumer market

If you thought that China was just the world’s largest market for commodities, you are mistaken. It is also the largest market for cars, electronic equipment, mobile phones, tablets, PCs and many white goods and non-durable products. In fact, 25% of the world’s car demand comes only from China. We have seen how the stock of Tata Motors got impacted the moment the Chinese slowdown fears surfaced. This is true of scores of products across the world.

So that is the precise reason the world is worried about slowing China. A combination of slow growth, weak demand and a volatile currency can create a tight situation for world markets. That is hardly what the markets had bargained for.

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