Some of the smartest minds in finance are making a prediction about China that was once taboo

china woman swallowing snakeReuters

It was once taboo to say that China could be a deflationary force, dragging the world into a slowdown as its own economy modernized.

Serious economists and investors pooh-poohed the idea, saying that China’s economy just didn’t have that kind of global impact. Just last weekend in a note to clients, Deutsche Bank’s Torsten Slok said the idea was overblown.

But it seems like all of that is changing. The once taboo deflation talk is all over the World Economic Forum at Davos, and the people who are doing the talking are some of the most brilliant minds in the market.

“I think the Chinese situation with the currency is very important,” said Ray Dalio, founder of $160 billion investment firm Bridgewater Asset Management.

“If there is significant currency weakness for the yuan that will mean more imported deflation, and it will make things more difficult.”

A force to be reckoned with

The idea that China could spread its malaise to the rest of the world has been discounted for years. The Economist argued that such claims were “inflated” as recently as September.

The Chinese government has done its part too. Last March, Chinese Premier Li Keqiang, who is responsible for the country’s economy, said in no uncertain terms that China wasn’t exporting deflation to the rest of the world.

It’s 2016’s volatile markets that have changed that.

At Davos, legendary hedge fund manager George Soros called China one of the “three major root causes” of global deflation, along with commodity prices and competitive currency devaluation.

And one could argue strongly that China is involved in those other two forces as well.

As China’s economy goes through the painful transition from an investment-based economy to one based on consumer spending, its demand for materials — especially commodities — that it once consumed in great volume has decreased, suppressing prices and hurting commodity sellers.

Meanwhile, China’s currency, the yuan, has been depreciating significantly against the dollar since December. The Chinese government’s expensive attempt to counteract that has caused volatility in global markets, and concerns over how much of its reserves China will have to expend keeping the yuan stable — keeping the world stable.

That doesn’t mean the yuan isn’t still going to fall though.

george sorosREUTERS/Christian HartmannGeorge Soros.

We’re hardly through it

Celebrated China analyst Charlene Chu wrote earlier this year that, as the Chinese government runs out of good options to stimulate the economy, the yuan is now part of its “playbook.”

“In our view, a much larger move [in the yuan] than 2015’s 4.6% is likely over 2016-17, the size and timing of which will be driven by the degree of capital outflows and extent of deceleration in GDP growth,” Chu wrote.

That puts the third deflationary force Soros was talking about into play — competitive currency devaluations. As China’s yuan falls, so might its neighbors’ or trading partners’ currencies.

jack lewMark Wilson/GettyUS Treasury Secretary Jack Lew.

Again, this isn’t to say that China is allowing the yuan to slide totally on purpose.

The government has expressed a desire to keep the currency stable and spent $108 billion in December alone doing so — so this isn’t about China “winning” as GOP presidential candidate Donald Trump might put it.

China’s currency depreciation now, said Treasury Secretary Jack Lew in a CNBC interview from Davos, is more due to its economic slowdown. The thing is, though, no one really understands how they’re handling it.

If they could be clearer about what they’re doing, I think that it will be helpful. I can’t tell you that I have 100% certainty of where they’re going,” he said. “I can tell you what they’ve announced as their policy. I can tell you what they’ve said in meetings, and I think their activities, their policies, and their communication have been confusing.”

So prepare for a wild ride.

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