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Albert Edwards: Chinese deflation may be biggest risk to markets

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The possibility of Chinese deflation could pose a greater risk to global markets than a reduction to the Federal Reserve's asset-buying program, according to a new research note by Societe Generale's Albert Edwards.

Global markets have been volatile ever since Fed Chairman Ben Bernanke first talked about paring back the central bank's massive monetary stimulus program in May. He has since emphasized that monetary policy will not be tighter for the foreseeable future, and on Thursday said it was still too early to tell when tapering will begin.

However, Edwards argued that instead of obsessing over Bernanke's comments, investors should focus their attention elsewhere.

(Read More: Goldilocks Chinese GDP a little too perfect for some)

"When will investors notice that China is flirting with outright deflation?" he asked in a note on Thursday. "The fact that China is on the verge of outright deflation may prove more important than even Fed tapering."

The Soc Gen global strategist said the difference between China's real and nominal gross domestic product (GDP) shrunk to 0.5 percent year-on-year in the second quarter - notably weaker than recent consumer prices data - indicating that China was nearing deflation territory.

"It is becoming apparent that China, on this data, is within a hair's breadth of outright deflation," he wrote. China's real GDP slowed to 7.5 percent year-on-year in the second quarter, while its nominal GDP slowed to 8 percent.

(Read More: Pros: Emerging markets look cheap, but still risky)

Currency dynamics have added to the risk of deflation, according to Edwards, with China's yuan heavily impacted by Japan's deliberate devaluation efforts.

"We identify China as suffering from excessive currency strength relative to regional competitors, both in nominal, and most especially, in real terms, as wage inflation ripped upwards a few years back," he wrote.

Since the beginning of the year, the yuan has risen by 1.43 percent against the dollar, at a time when most emerging market (EM) currencies have experienced a massive sell-off.

However, Edwards said the EM region as a whole was starting to look more attractive, despite describing himself as a "long-time skeptic of emerging markets".

(Read More: Yuan as global currency? Many firms don't see benefits)

"Despite more macro pain to come, the EM universe is beginning to look cheap, and certainly much more attractive than developed markets," he wrote.

EM currencies, equities and bonds have been hit hard this year by concerns over Fed tapering, slowing growth in China and weakening commodity prices. The MSCI emerging markets index has fallen by over 11.5 percent since January.

Referring back to a research note of November 2011, in which Edwards jokingly gave the economies of Brazil, Russia, India and China a new name, he added on Thursday: "BRICs might not now be the Bloody Ridiculous Investment Concept they once were."

-- By CNBC's Katrina Bishop. Follow her on Twitter @KatrinaBishop

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