A little too quiet?
16 January 2018
While we are broadly optimistic about the outlook for emerging market economies – commodity prices have improved, policy is still accommodative, Chinese growth is stable, and DM demand appears to be improving – there are many risks to this outlook. First and foremost is the potential impact of monetary policy withdrawal on global liquidity conditions and EM capital flows. While moves in US short-term rates have little impact in and of themselves on broader EM economies (small, open economies are the exception), if the Fed moves faster than expected the risk exists that it could trigger a reversal of risk sentiment and cause a broad strengthening of the US dollar. Worse, this tightening could disrupt the positive global growth backdrop.
Should this happen it would be hard to hold a positive outlook for EM. After all, the dollar and associated moves in commodity prices and capital flows are perhaps the most important factors behind EM’s fate. Periods of strong EM inflows have almost always been characterised by a weak dollar, and a strong dollar has almost always been associated with EM outflows (see Chart 10). A stronger dollar is generally associated with weakening commodity prices, which in turn impact nominal EM exports and general liquidity conditions. The emerging x-factor in this potential sequence of events is China. In an environment of tightening US monetary policy and a broadly strengthening dollar, Chinese policy choices can either positively offset, or potentially exacerbate, Fed policies. If China maintains accommodative credit and fiscal policies, growth can stay stable in China and commodity prices can be supported by Chinese demand. Stimulus out of China can serve to bolster EM’s current accounts at a time of reversing dollar conditions. Additionally, China’s currency and capital control policies matters; if China allows the RMB to appreciate in a trade-weighted fashion, and thus stays stable bilaterally against the dollar, China can serve to bolster EM sentiment at a time when risk sentiment would naturally reverse. Alternatively, if China overtightens or chooses to depreciate in the face of dollar strength, stress on EM could amplify. As such, our base case remains gradual, signalled rate rises in response to broad global growth that does not trigger a dollar rally. Additionally, EM is buffered by relatively high real interest rates and a current account that has moved into surplus. Nonetheless, an alternative scenario to our base case could spark EM stress.
Another area where current complacency could materialise differently is around politics, particularly the US-China economic relationship. With so much of the recent US-China relationship wrapped up in cooperation over North Korea, nuclear progress by the North and recent talks between the North and South presents a new paradigm where it is clear China is unwilling or unable to prevent NK nuclear achievements. The sanctions to-date have only had limited impact, with imports as a percentage of total trade still well above the long-term trend, while exports are stable (see Chart 11). With the administration now faced with a policy adjustment from “preventing a nuclear-armed NK” to deterring a nuclear NK, this removes constraints on taking a more forceful approach to perceived Chinese economic imbalances. Additionally, economic conflict between the two counties could take a broader, more damaging form, focused on corporate market access and bilateral investment rather than just tariffs.