Lyon: potential China capital reserve collapse a game changer

The pause in expansion of China's capital reserves may be a game changer for the world economy, Sebastian Lyon has said.

The AAA-rated Trojan and Personal Assets star argued in his latest note to clients that such a contraction in the Tiger's reserves has not been seen in more than a decade, at which point a deflationary shock triggered a Russian default.

Although the rest of the world is keeping a close eye on the UK, eurozone and US because of sluggish growth, too much debt and a pending fiscal cliff, Lyon said he is also watching China 'with interest'.

Lyon explained: 'China's capital account reserves, which had been growing at a rate up to 50% a year for a decade or more, have stopped expanding. This could be a game changer for the world economy.

'The last time there was such a collapse was in 1998 - when a deflationary shock led to Russia's default.  Since 2007, China's export prices are down 6%, while wages are up by 70%.  Profit margins (for capital providers) have taken the strain on returns on capital have fallen.'

China's difficulties are clearly evident in its domestic equities, with Shanghai's stock market now hugging its four-year low.

Like a number of fund managers, Lyon pointed out to his investors that high periods of growth do not always translate into high returns, and the combination of these difficulties has caused China's currency to become less competitive.

Lyon believes policy makers are likely to view devaluation as a way out of these troubles.

'The way out of this quandary is the invidious choice between deflation and devaluation,' he said.  'Politicians are likely to choose the latter. We will watch with interest.'