George Kerevan: When China sneezes, prepare to catch a cold

Around the globe, equity markets lost their appetite for risk this week. As well as the Crimean anschluss, economic difficulties in China added to the air of pessimism.

China has just suffered its first corporate default since the creation of the domestic bond market two decades ago – a Shanghai solar power company. On Thursday, premier Li Keqiang warned that more defaults are “unavoidable”.

The Chinese Communist Party responded to the global recession of 2008 by opening the credit floodgates and pumping unprecedented amounts of capital investment into the domestic economy. Corporate and personal debt jumped from 120 per cent of GDP to 250 per cent. Fearful of exploding inflation and attendant social unrest, China’s leaders decreed an official credit squeeze last year.

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But this move only resulted in the country’s semi-legal “shadow” banks increasing loans dramatically. Now Beijing has declared war on these private banks – hence the defaults. This second credit squeeze is deflating the Chinese economy. Data published on Thursday shows that fixed investment, retail sales and factory output have all slumped to multi-year lows.

Why worry? Because $1.1 trillion (£700 billion) of Chinese domestic debt has been provided by Western banks acting through Hong Kong and Macao middlemen associated with China’s shadow banks. And many of these Western banks are British.

Draghi’s optimism hits the tip of the iceberg

TheRE is one part of the financial world where unalloyed optimism reigns supreme: the European Central Bank (ECB) in Frankfurt.

On Thursday, ECB boss Mario Draghi held a press conference to explain he was not worried in the least by the prospect of deflation in the eurozone. Instead, he argued, the euro will soon start falling in value, raising the real inflation rate in Europe.

Draghi is doing a passable impression of the captain of the Titanic just before it hit the big block of ice. The eurozone is already in deflation. The Eurostat HICP index shows prices are falling in Belgium, France, Greece, Italy, the Netherlands, Portugal and Spain. The crises in Ukraine and China will only force up the value of the euro, as investors flee risk. That adds to deflation, which makes the real value of Europe’s corporate, personal and sovereign debt heavier still. Result: a drag on growth.

There’s an old rule that when central bankers try to talk up a currency, then is the time to sell.

Perversely, Draghi is trying to talk down the euro, in the hope it will magically turn deflation into inflation. His optimism is woefully misplaced.

Those Scottish public spending figures again

The latest Gers data on Scottish public spending provoked predictable headlines that North Sea oil revenues are too volatile for a small, independent Scotland to cope with.

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It shows oil revenues fell by £4.5bn in 2012, raising the notional Scottish budget deficit to 8.2 per cent of GDP compared to 7.3 per cent for the UK.

Of course, that assumes Scotland would have incurred the same expenditures. The MoD’s spending on its foreign wars in that financial year came to £4.5bn. Assuming Alex Salmond would not have fought those wars, stripping out Scotland’s share cuts the notional deficit substantially. Besides, the UK suffered two quarters of economic contraction in 2012, while Scotland did not.