Emerging markets rose to prominence in the mainstream conscience lumped all together. Individually, they were less attractive and often considered too risky. That was helpful in raising their profile in global financial centers.
Such association is now looking like less of a good thing as serious economic turmoil in some developing nations has, in the eyes of investors, tarnished all of them with the same brush. Questions are now even being asked of China, the long-time poster boy for this group.
In December the US Federal Reserve started scaling back, or tapering, its long running quantitative easing program. Since then asset purchases have been trimmed to US$65 billion a month from US$85 billion, triggering widespread capital flight globally. The results have not been kind on places like Indonesia and Turkey and have amplified the uncertainty over emerging markets that first appeared last summer when talk of tapering turned serious.
Until now, China has looked largely stable. Many of the fundamental issues causing pain elsewhere such as current account deficits and small supplies of foreign currency do not trouble Beijing. “The overall effect [of tapering] on China will probably be limited, as China has a current account surplus and the world’s largest foreign-exchange reserves,” Ivy Pan, a Hong Kong-based analyst with ABN Ambro, wrote in a research note in late January.
But an increasingly anxious global marketplace is starting to ask deeper questions about the health of China. Some investors see the risks posed by tapering to exports and the domestic financial market as a trigger that could throw the whole economy off kilter.
Exports re-routed
Chinese exports to developing markets have boomed in recent years. As those places grew richer their emerging middle classes sought a greater variety of consumer goods. Those regions now account for about 50% of the world economy and helped offset weak demand from rich nations in the years immediately following the financial crisis.
Giant container ships departing China for exotic destinations might soon be carrying much lighter cargoes. Since the beginning of December, Argentina’s peso has fallen by about 20% versus the dollar while the Turkish lira is down around 8%, making imported goods much pricier. Interest rate hikes by central banks in Ankara and Brasilia designed to stop foreign capital from fleeing will hurt the credit-driven consumer boom in those countries.
Dockers in Los Angeles and Portland on the other hand can expect more work unloading vessels from Shanghai and Guangzhou. The Fed is tapering because American unemployment is falling below 7%, which indicates growth in economic activity. Stronger consumption in key developed markets will offset a slowdown in Chinese exports elsewhere; roughly 20% of goods shipped from China are destined for the US compared to the 15% bound for emerging markets.
US consumers might soon be able to get more for their buck. “QE tapering could make the US dollar stronger, which would strengthen its purchasing power and import demand,” Cao Yongfu, an assistant research fellow at the China Academy of Social Sciences, wrote in an opinion piece.
Money flows
Of potentially greater concern is financial stability in China as this is where risk has piled up. Tapering could inflict serious damage if it prompts a severe outflow of capital.
China faces the prospect of volatility from global capital movement. Investors might prefer to move their money to the US, where interest rates are expected to start rising, while the gradual economic recovery there makes it an attractive destination overall, noted Cao. China recorded net capital outflows in 2012 after being a net recipient in the preceding three years.
Top officials in Beijing are cautious, asking Washington to consider the global implications of changes to its monetary actions. “We call on the US to work as a responsible major country and to be responsible for the spillover effect of its policy,” Zhu Guangyao, vice minister of finance, said in late December after a meeting with US officials.
Pressure is likely to mount in the short term and could seriously disrupt the business environment. Domestic monetary conditions are tight and the People’s Bank of China (PBOC) appears determined to keep a rein on things. January saw record credit expansion to which the central bank responded by unexpectedly draining liquidity from the market on Tuesday. Capital outflows will only add to the difficulties companies face in accessing vital financing.
Still, the broader impact of capital flows is unlikely to have anywhere near the damaging impact currently being felt in places like Jakarta. Crucially, China does not depend on short-term borrowing from overseas to pay for what it spends, and has the means to deal with problems.
“The experience of the tapering scare back in middle part of this year [2013] suggests that the most vulnerable economies are those with sustained current account deficits and those that rely heavily on foreign capital inflows to fund domestic growth,” JP Morgan chief China economist Zhu Haibin wrote in a note in January. “From this perspective, China is indeed in a solid external position, which is why China was little affected by the previous tapering scare.”
Senior officials also have the ability to loosen domestic liquidity through their own means. One of these is scaling back the amount of money banks need to hold in reserve to inject more cash into the real economy. This is an oft-deployed monetary tool by the central bank. Strict capital account controls meanwhile prevent the rapid movement of money over borders.
If anything, top foreign exchange officials are bracing themselves for capital inflows this year. That would add to the massive US$138.8 billion current account and US$199.2 billion capital and financial account surpluses recorded in the first nine months of 2013, bolstering China’s ability to withstand any stampede by investors to the departure lounge.
Wealth of the nation
“China’s economic fundamentals are much healthier than most other EMs and China is one of the least vulnerable EM economies to US tapering in 2014,” Ma Jun, chief China economist at Deutsche Bank in Hong Kong, concluded in a recent note. Nevertheless, the country does face some risks from tapering and needs to be alert to the problems that can arise.
China is the world’s largest holder of US Treasury debt. It has been buying the paper to keep its currency weak and fuel global consumption of the goods it exports. But its holdings are now so vast that any decline in their value would be painful. This threat now looms as US interest rates are expected to pick up from the lows they have been at since 2009. In response, last December China conducted the biggest sale of such assets in nearly four years.
Advocates of liberal economic reforms see tapering as an opportunity for China to get its house in order. They argue that emerging markets will see slower growth in the coming years while rich nations will take time to get back to full strength. Therefore, China needs to drive more growth internally and further secure itself against the possibility of external shocks.
“The end of monetary easing in the US will bring unprecedented financial risks to a China already facing slowing growth. China has no choice but to reform its economy,” Hu Shuli, editor of the influential business magazine Century Weekly, wrote in an editorial.
Beijing is already moving in that direction, and needs to stick with it. “China is implementing the most aggressive structural reforms in decades, while this determination is not seen in most other EMs due to po
litical stalemate,” noted Ma. “China’s new reform program, especially deregulation, would enhance the country’s growth potential and reduced macro risks.”