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China is the real threat to emerging markets

11-02-2014 | News item | Léon Cornelissen It has been a rough time for emerging market equities, but only China has the real power to upset the apple cart for investors this year, says Robeco’s chief economist.

Speed read:
  • Stock prices plummet as Fed begins tapering
  • Rate hikes as countries defend currencies
  • Dilemma for investors over capital flight
  • Chinese uncertainty is the bigger problem
Rate hikes in countries such as India and Turkey to try to prop up their currencies and cut capital flows have sent stock prices plummeting. Much of the malaise has been blamed on the US Federal Reserve (Fed) for beginning its tapering program.

Cutting the amount of US monthly bond purchases means interest rates will gradually rise, making investment money flow back into richer, western economies away from poorer developing markets. That has produced capital flight, including money tapped from emerging market stocks.
 
However, investors need not fear a backlash over what is actually a return to more normal economic conditions in the west: the real threat is if China starts running into problems, says Léon Cornelissen in his monthly outlook.

Important questions for investors
“The unexpected and brutal sell-off in emerging market equities poses some important questions for investors,” he says.
These are:
  • “Will the Fed change course, shortly after tapering its bond-buying program has started in earnest?
  • Will the recovery in advanced economies be derailed by the growing problems in selected emerging markets?
  • Do current events materially change our view on the performance of asset classes in 2014?”
The short answer to all these questions is no - unless China weakens considerably - says Cornelissen.

The reason for this is China’s muscle as the world’s second largest economy and generator of much of its growth. “Things could become different if the Chinese economy materially weakens further, due to its size,” he says.

‘Things could become different if the Chinese economy materially weakens’

“The Chinese authorities have slowed down economic growth recently in an effort to curb housing prices and tame the shadow banking system. More importantly, they presented at the latest Communist Party Congress an ambitious reform program, which in practice would mean lower structural growth. But it is unclear what may eventually happen.” 

Chinese New Year complicates matters
China remains problematic because “the policy preferences of the Chinese leadership are unclear,” says Cornelissen. In 2013, the Chinese leadership demonstrated a very low tolerance for a growth rate below 7%. “We therefore expect that China will strive for a similar growth rate for 2014 and would pump up growth if deemed necessary,” he says.

“With foreign reserves exceeding 40% of GDP, a structural budget surplus, massive domestic savings and a relatively low central government debt, Chinese policy makers have ample room for maneuver. However, an assessment of the current state of the Chinese economy is complicated by the Chinese Lunar New Year, which makes the interpretation of the trend in economic data in the coming two months especially complicated. China remains therefore a wild card in the coming months.” 

‘Chinese policy makers have ample room for maneuver'

Stop blaming the Fed! 
In the meantime, let’s stop blaming the Fed for the problems now faced by emerging markets, says Cornelissen. Most leaders of emerging economies did not complain when money started flooding into their countries when quantitative easing began three years ago – and now that the good times are over, capital flight is only to be expected, he says. It also is not the principle reason behind their recent difficulties.

“The current problems in selected emerging markets cannot be primarily attributed to the tapering decisions of the Fed,” says Cornelissen. “The policy mix in emerging markets has been too loose, as suggested by factors such as the current account deficit of Turkey rising to more than 7% of GDP.”

“The phrase ‘fragile five’ was coined to highlight the vulnerability of Brazil, India, Indonesia, South Africa and Turkey due to their current account deficits. The policy mix has to change, though it would be a bad idea trying to stabilize exchange rates vis-à-vis the US dollar by hiking interest rates prohibitively high.”

JP Morgan Emerging Market Currency Index (% YOY) 

jp-morgan-emerging-market-currency-index.jpg
Source: JP Morgan

Weaker growth won’t derail West
“The weakening of emerging market currencies will contribute to a rebalancing of their economies and a lowering of current account deficits. Weaker growth in selected emerging markets will therefore be unable to derail the ongoing recovery in developed markets. Their economic clout is too small. It could of course contribute to a weakening of commodity prices, which ironically would actually further strengthen the recovery in advanced economies.”

Critics accusing the Fed of adopting a parochial policy have noted that recent statements don’t refer to the turmoil in emerging markets, unlike more tactful policy statements by the European Central Bank.

‘The economic clout of emerging markets is too small’

“The Fed is well aware of the external impact of its policies, but in the highly polarized political atmosphere in Washington, it prefers to communicate within the limits of its mandate,” Cornelissen says. Indeed, critics within the US had previously accused the Fed of not being nationalistic enough.

He says the Fed won’t back down from its tapering program because the current strength of the US economy is probably underestimated. Fourth-quarter GDP growth was once again a positive surprise, as was the third-quarter figure. The US government won’t be a drag on growth as in 2013 due to severe sequestration, where it is legally obliged to cut the deficit by reduced spending. And the non-manufacturing PMI rose in January to 54.0 from 53.0 (a figure above 50 indicates growth), suggesting further strengthening.
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