China, the Fed and emerging markets
Yuan thing after another
A cheaper yuan and America’s looming rate rise rattle the world economy
Aug 15th 2015
THE cloud hanging over emerging markets seemed to darken in the past week. As it was, fears that the Federal Reserve is about to raise rates, pushing up debt-servicing costs and sucking capital out of emerging markets, had been weighing on currencies and stockmarkets from Brazil to Turkey (see chart). Now a fresh worry is blotting the horizon. On August 11th China engineered a small devaluation of the yuan, prompting concerns that, with growth sputtering, its government was ready to risk a global currency war.
The angst about the state of the world’s two biggest economies is understandable. China’s economy has slowed markedly: it is likely to grow by 7% this year, its most languid rate in a quarter-century. In addition the government has been trying to reorient the economy from investment to consumption.
For emerging markets that had been catering to China’s investment binge—those selling it coal and iron ore, copper and bauxite—the past few years have been little short of brutal. The economy’s slowing and rebalancing explain much of the 40% fall in commodity prices since their peak in 2011 and, by extension, the travails of countries which make their fortunes digging stuff out of the ground, from Peru to South Africa.
For other emerging markets, the importance of China as a source of direct demand is less pronounced. Exports to China account for less than 9% of total shipments from developing countries, calculates Jonathan Anderson of Emerging Advisors, a consultancy, whereas exports to the rich world account for 55%. For countries exporting food and fuel—the majority of the global resource trade—China’s slowdown has had a limited impact. Except for a small group of countries heavily concentrated on exports of ores and minerals, “China has hardly mattered at all,” he says.
China can make itself felt in other ways, however. A slowdown in the world’s second-largest economy, for instance, is bound to have second-order effects on demand. Deflation in China puts pressure on firms in other emerging markets to cut prices. And some worry that the yuan’s fall may initiate a series of competitive devaluations, with other exporters racing to weaken their exchange rates or, perhaps, resorting to trade barriers as a last resort.
Fortunately, the changes to China’s exchange-rate regime do not seem nearly big enough to set such a vicious cycle in motion. Even after its devaluation, the yuan remains stronger than it was a year ago in trade-weighted terms. Moreover, the authorities are now intervening to slow its decline. In other words, the depreciation is a small, belated step to keep the yuan’s value in line with those of its peers, not a dramatic shift in exchange-rate policy.
China’s slowdown continues to amplify jitters about the Fed’s impending “lift-off”. The sensitivity of developing countries to changes in policy at the Fed was amply illustrated by the “taper tantrum” of 2013, when the announcement that it would slow and eventually stop its huge purchases of government bonds led to turmoil in emerging markets.
An American rate rise, which may come as soon as September, could put pressure on emerging markets in a variety of ways. Rising rates will add to the allure of American assets, potentially making the dollar even stronger. For the governments, households and firms in the developing world that have borrowed trillions of dollars in recent years, interest and repayment costs will climb in terms of local currency. If fears about their debts lead to more outflows of capital, central banks in the weakest countries will face an invidious choice between letting their currencies plummet and ratcheting up interest rates to defend them. The former will only aggravate the burden of their foreign-debt load; the latter will stifle growth. Bill Gross, the world’s best-known bond manager, has spoken of a “currency debacle” for emerging markets.
Not all agree that higher American interest rates need spell doom. That the Fed has been edging towards lift-off is no secret. Anticipation of this is one reason for the dollar’s recent strength. If its tightening is gradual, as expected, emerging markets may fare better than feared.
The presumption that the dollar strengthens when the Fed raises rates is not borne out by evidence. In the first 100 days of its four big tightening cycles of the past 30 years, the dollar has actually weakened every time, according to David Bloom of HSBC, a bank. The notion that Western central banks’ efforts to keep interest rates low sent a torrent of money into emerging markets that is now about to drain away may also be wrong. Average quarterly flows from America to emerging markets were actually higher before the crisis, according to Fitch, a ratings agency. If so, monetary policy in America may not be the be-all and end-all for emerging markets. That, at any rate, will be their hope.