After October’s violent but fleeting relief rally in emerging markets, the vicious circle of US monetary tightening, a strong dollar, slowing Chinese industrial demand and collapsing commodity prices has once again emerged and re-applied the pressure.
Following the seeming collapse of the OPEC, oil continues to lead the charge lower in commodity prices. While the speed of the decline means another short squeeze rally could be imminent, we have little confidence that a ‘true’ bottom for the commodity complex is close at hand. Still rising oil inventories in North America suggest more pain ahead.
Downside risks to iron ore and steel prices also remain palpable. China’s strategy of maintaining domestic output, in the face of wilting consumption, by flooding world markets with its excess capacity is ultimately unsustainable, particularly as Australian supply continues to increase.
With India the latest to retaliate, the inevitable protectionist backlash means that 2016 appears destined to see China’s steel output, currently flat over the last year, move more in line with domestic consumption which has fallen by over 4% this year.
Given the tight relationship between global commodity prices and the dollar, the outlook for further appreciation of the dollar—as the US Federal Reserve slowly but steadily continues to nudge up interest rates next year—is another reason to remain cautious about commodity prices.
By generating an income and, hence, current account shock for commodity exporters, the inverse and highly-elastic relationship between the dollar and commodity prices is one of the key channels through which a stronger dollar produces global monetary tightening.
A second channel is via the capital account as rising US rates prompt outflows and tighter liquidity conditions as central banks intervene and run down foreign exchange reserves to either defend pegs versus the dollar or, alternatively, limit the scale of depreciation.
The outlook for the Chinese renminbi remains pivotal. Despite having achieved the long-held political ambition of inclusion into the IMF’s Special Drawing Rights, short-term pressure on the currency remains acute, underscored by November’s bigger-than-expected FX reserve drawdown, of almost $87.2 billion.
The Chinese authorities appear to be succumbing gradually to the outflow pressure and the central bank announcing on December 11 that it will now publish a trade-weighted renminbi basket; a move clearly intended to foreshadow a regime shift to targeting a trade-weighted basket rather than just the greenback.
Given the continued downward pressure on Chinese nominal rates as the authorities seek to rebalance the economy away from heavy industry and exports towards services, a continued de facto pegging of the renminbi to the dollar increasingly makes little-or-no macro-economic sense now that US interest rates are finally starting to rise. A shift to managing the currency against a wider trade-weighted basket is a sensible move, but still leaves the Chinese authorities with a classic ‘exit’ problem: how to increase currency flexibility without further exacerbating hot-money outflows and depreciation pressure in the short-term?
How much weakness the Chinese authorities are prepared to accept in 2016 remains unclear and to some extent will be determined by how much the dollar strengthens further against the euro and the Japanese yen. What is clear is a weaker Chinese currency is deflationary for the global economy and represents another downside risk to commodity prices.
There is a third dimension to how a strong dollar hurts emerging markets. The last five years have seen an unprecedented build up in EMs’ dollar liabilities—both on- and off-shore—as borrowers appear to have substituted local currency debt for US credit, given ultra-low US rates and previously optimistic assumptions about local currency appreciation versus the dollar to both lower financing costs and to indulge in a form of the ‘carry trade’.
Vocal in stating the risks from this surge in dollar credit outside the US, the Bank for International Settlements finds that total non-bank US dollar credit in emerging markets had soared to around $3.3 trillion by mid-2015. While much of the debt is still dominated by bank loans, on- and off-shore corporate bond issuance has surged over the last year, particularly in North Asia and Latin America. On average, dollar bond issuance has grown faster than bank loans since 2009.
The World Bank has pointed out that much of the corporate debt taken on has presumably been issued by commodity exporters or other firms producing tradeable goods. In principle, therefore, their foreign currency earnings should act as a natural hedge against USD liabilities.
However, given that commodity prices appear to be both negatively and elastic with respect to US dollar appreciation, a stronger dollar is likely to be a net negative on average. What seems clear is that the stronger the greenback is next year, the greater the risk of rollover and other refinancing crystallising and further intensifying the downdraft facing EMs.
Therefore, 2016 promises to be another year of angst for EMs, with GDP growth forecasts continuing to slide and pressure on FX persisting until a clear bottom in commodity prices is reached and/or the US Federal Reserve signals the all-clear. Neither, particularly the latter, looks likely for the foreseeable future.
India continues to stand out as a rare bright spot amongst emerging markets. As a net commodity importer, particularly of oil, India’s ‘policy space’ is expanded by commodity deflation in contrast to most emerging markets. Oil’s continued swoon gives Reserve Bank of India more chance of hitting its demand 5% inflation target set for early 2017 despite this year’s deficient monsoon and the inflationary risks prompted by the Seventh Pay Commission. The apex bank may yet be able to squeeze through another 25 bp rate cut to support growth. Fiscal space is also augmented by lower oil prices , allowing finance minister Jaitley to remain on course to hit his 3.9% deficit target even as the Centre’s capital spending shows a welcome acceleration. Overall, 8% GDP growth for FY2017 looks achievable, leaving India as the fastest growing of all the emerging markets.
The author is chief economist (emerging markets and Asia ex-Japan), BNP Paribas