EUobserver opinion: Where does the US-Chinese turmoil leave Europe?

About a week before last Friday, the People’s Bank of China (PBoC) adjusted the exchange-rate of the Chinese yuan against the US dollar to better reflect market conditions. The net effect was a devaluation of 1.9 percent relative to the dollar.

Critics saw the PBoC’s adjustment as still another signal that the slowdown of Chinese growth is worse than anticipated.

However, that slowdown simply reflects the shift of China’s growth model from investment and exports to consumption and innovation. This shift will take another decade.

Others argued that China’s devaluation was the opening shot in a “currency war” that would spread internationally. In reality, jumpstarting exports and growth tends to require a devaluation of 10-20 percent to be truly meaningful. In that regard, China’s 2 percent devaluation is grossly inadequate.

Still others saw China’s exchange-rate adjustment as an effort to comply with the requirements of the International Monetary Fund (IMF) to include the yuan in the major reserve currency basket.

Indeed, the move toward a more market-determined rate is precisely what the IMF and the US Treasury, along with European financial authorities, have been asking for.

US correction was expected

For some time, Wall Street has anticipated market correction. After all, market valuations no longer reflect fundamental economic realities.

Markets have shrugged off even international signals, including the plunge of energy prices, stagnation in Europe and Japan, growth slowdown in emerging economies, the tumult in the Middle East, and sanctions against Russia.

The simple reality is that US markets have been very expensive. That is reflected by indicators, such as the so-called CAPE (cyclically-adjusted price/earnings ratio). In the US, the historical average has been 15. But before the recent turmoil, that ratio was around 26 in the US - very close to its previous peak before the global recession in 2007.

That valuation might be understandable if it was based on fundamental realities. But it is not. The reason is excessive leverage in the US.

Since 2010, the Eurozone has struggled to cope with its debt burden. That’s not the case in the US.

In the past half a decade, US economy has enjoyed extraordinarily low rates, and rounds of quantitative easing amounting to $4.5 trillion. Meanwhile, US sovereign debt has soared to $18.4 trillion; that’s more than the size of its economy.

Yet, there is no credible, bipartisan plan in the US to resolve the massive debt burden. In effect, if there is no agreement in the next few weeks, Washington could face another government shutdown in October.

Against these odds, US Federal Reserve is expected to begin its first rate hikes in the fall. Many observers consider that risky to ordinary Americans, emerging economies and global growth prospects.

While US unemployment rate has declined to 5.3 percent, long-term unemployment is today higher than in decades.

What’s worse, the Fed’s own target for rate hikes is 2 percent inflation. Yet, inflation in the US is not likely to exceed 0.1-1 percent in the fall.

Europe’s vulnerabilities

While European economies have been impacted adversely by recent Chinese volatility, the turmoil in the region’s markets began with the global crisis in 2008, has deepened with the debt crisis since 2010 and been recently fuelled by political divisions over the third Greek bailout.

While Europe suffers from structural challenges, the region is enjoying a mild cyclical recovery, thanks to the European Central Bank’s quantitative easing and low interest rates, a significantly weaker euro, record-low oil prices and greater restraint from EU authorities.

The challenge is that the current rebound relies excessively on growth in Germany and Spain. While economic prospects look mildly better in France and Italy, their growth rates are not likely to reach the pre-crisis levels anytime soon.

Moreover, the political environment is in flux and anti-system protest parties continue to gain momentum.

In the past week or two, markets have been struggling with correction globally. The plunge stopped only after Beijing cut interest rates for the fifth time in nine months along with reserve-ratios. As a result, US and global markets rallied initially, while unease prevails in Chinese markets.

Europe is in no way immune to market turmoil. Unlike the Chinese yuan, the euro plunged some 15 percent against the dollar in just a year. If the US Fed will start rate hikes prematurely, markets will quickly sink again and the Fed must begin rate cuts anew.

The adverse consequences would be global and substantial in Europe, due to the region’s broad and deep trade, investment and financial ties with the US.

Today, the challenge for the world economy is the absence of adequate cushions against economic contractions and market falls.

Dan Steinbock is research director of international business at the India, China and America Institute (USA) and a visiting fellow at the Shanghai Institutes for International Studies (China) and EU Center (Singapore)