Emerging markets: Big trouble from brittle China

Sid Verma
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The January fall in emerging market currencies, the exodus of foreign capital and a global bear market in equities all point to a new financial crisis. How China reacts to this threat holds the key for emerging markets.

In a crisis emerging markets tend to show their true colours – as an illiquid, high-beta bet on US rates, Chinese growth and commodity prices. So following a rise in US interest rates, as Beijing posted the slowest annual rate of expansion for 25 years and oil prices fell below $30 a barrel, EM currencies slumped to a record low in January. 

According to the Institute of International Finance, net capital outflows from emerging markets, led by China, hit a record $735 billion in 2015. Investor fears over a wave of debt defaults have increased. EM debt stands at an all-time high at $58 trillion, or 200% of emerging market GDP, according to BCA Research, with corporate leverage above 90%, at $25.5 trillion. 

Some $8 trillion was wiped off the value of global equities in the first three weeks of 2016. Spreads on developing-country government debt also hit 2009 crisis levels, as EM currencies hit lows not seen since the Asian crisis, even in investment-grade countries with current-account surpluses, such as Malaysia. 

Analysts fear that the attempt by EMs emerging-market policymakers to reflate their economies through a private sector-led debt expansion has sown the seeds for a new China-led global crisis. Standard & Poor’s data show EM companies were responsible for a fifth of the 112 corporate defaults last year, with this share expected to rise in 2016. The outlook for emerging markets is worrying as rising US interests rate and a strengthening dollar deflate EM assets and increase debt-servicing costs. At the same time, the fall in the renminbi and Chinese deflation raise the spectre of competitive currency devaluations. 

China SV commodity-350
China holds the key. It accounts for a third of EM GDP, over half of their debt burden and drives liquidity and capital inflows for Asian exporters and global commodity producers. For the last two months China has been in the grip of a crisis as capital flows out and foreign-investor confidence in its exchange-rate regime collapses. In the first two weeks of January, $635 billion was wiped off the value of the Shanghai Composite Index, while the People’s Bank of China spent $120 billion in December alone to defend the renminbi. The PBoC has vowed to defeat "speculative forces" in the currency market and has suspended the FX operations of banks including Standard Chartered and DBS.

At the heart of Beijing’s problems is its failed December switch from an effective dollar currency peg to a trade-weighted basket. Markets have seen this shift as a barely concealed bid to devalue the currency to boost exports – a move that could lead to a currency war in a period of weak global demand. The direct link between the equity market and the Chinese real economy is relatively weak, however. Few companies raise equity capital through public listings and a large proportion of shares are owned by state entities. However, markets fear policymakers have lost control of the levers of the economy while neglecting supply-side reforms, all setting the stage for a full-blown crisis. 

The immediate challenge for China is to control its monetary policy amid domestic outflows and an overvalued currency. It faces a policy bind that has trapped many EM economies – the impossible trinity of managing exchange rates, allowing the free movement of capital and maintaining an independent monetary policy, all at the same time. 

Monetary trap

In December, Euromoney reported candid remarks from Chinese policymakers revealing their worries over the monetary trap. Wu Xiaoling, former PBoC vice-governor and vice-chair of the financial and economic affairs committee of China’s national legislature, said then: "The biggest conflict [for monetary stability] is relying on a single currency, and we now encounter the Triffin dilemma," referring to the tension revealed by the Fed’s determination to set monetary policy according to domestic conditions, despite the dollar’s role as the world’s reserve currency. 

Karthik Sankaran, director of global strategy at Eurasia Group, explains the policy challenge: "China is confronting the exchange-rate implications of cyclical divergence between its economy and that of the US, which necessitates easier monetary policy there at the same time that the Fed is looking to raise rates. Changes in household sector and corporate exchange-rate expectations are driving renminbi weakness, to which Chinese authorities have responded with FX reserve drawdown and ad-hoc regulatory pressure to temper the pace of depreciation. The scale of reserve drawdown in recent months has led to fevered speculation about China undergoing an archetypal EM crisis along the lines of the 1997-98 Asian crisis."

Domestic demand in China for liquid foreign assets could be as much as $3 trillion, according to some estimates, and if outflows continue, FX reserve depletion and a run on the renminbi are possible. Until market expectations for the exchange rate stabilize, China will be forced to continue deploying reserves to defend the renminbi, which will tighten monetary conditions and exacerbate the economic downturn. 

China could continue to cap interbank rates, but this would weaken the currency further, fuel capital flows and increase capital misallocation after a post-crisis spending binge that has helped to saddle the country with a total debt-to-GDP ratio of around 250%. A lack of monetary stimulus, however, combined with chronic domestic over-capacity and a weak service sector could precipitate a recession.