The biggest external risk concerns China. Its real exchange rate has become overvalued. It is heavily exposed to developed world countries ratcheting down their real exchange rates. Since abandoning the fixed 8.28 yuan/dollar rate in 2005, China’s unit labour costs have been rising at 7 per cent a year, and its currency by 4 per cent, for a combined annual 11 per cent in dollars.
Overvaluation became a serious problem in 2011. Producer price inflation (PPI) of 7 per cent then matched unit labour costs (in yuan), but crumpled into 2-3 per cent producer price deflation over the past couple of years. April’s 2.6 per cent deflation has intensified from 1.6 per cent in February. Chinese businesses have to slash prices to keep a grip on their export markets. But unit labour costs are still rising at a 5 per cent rate, squeezing profit margins, and are up 20 per cent relative to the export competition since 2011.
Adding to this problem is the sudden, related, swing into high real interest rates. In mid-2011, the one-year lending rate from state-owned banks was 6.6 per cent, which combined with 7 per cent PPI to give a slightly negative real rate. But a flight of depositors from China’s banks has kept nominal interest rates high. The nominal interest rate is only down to 6 per cent now, but combined with PPI deflation, the real interest rate is close to 9 per cent. Such high real interest rates combined with squeezed profit margins have pushed China into a prolonged “investment-led” slowdown.
That is from Charles Dumas, here is more. Dumas also notes that China is especially heavily invested in assets which are interest-rate sensitive in value.