China crisis
Similarly, take the second issue at the heart of events at present: uncertainty about the Chinese economy and exchange rate. As the Chinese RMB has traditionally been closely pegged to the dollar, US monetary policy gets exported to China. This means that a strong US economy and a weak Chinese economy give rise to a tug of war at the centre of the global financial system.
Hence, market stress is in principle reasonable. However, I believe the market’s current pessimism on this issue is over the top. This is because the policy solutions are simple, feasible and being executed by the US and Chinese authorities. They are threefold and work best in combination.
l The Fed must tread cautiously, releasing hawkish communication only when capital flows out of China are relatively becalmed. This is exactly what the Fed did last September, when it decided against raising interest rates at that time. I believe it will do so again with respect to the next rate hike.
l China can use fiscal policy to adjust domestic demand conditions to a strong exchange rate – and this is what the Chinese government is judiciously doing.
l China can change its exchange rate policy, by allowing the RMB to depreciate against the dollar in the face of dollar strength, and – given the authorities’ reluctance to allow the RMB to float freely at this point – manage it against a basket of major currencies rather than the US dollar alone. Again, this is exactly what China is doing.
So why, so far, has the market reacted so negatively to RMB depreciation against the dollar? My guess is that it is down to the market’s ‘trust issue’ vis-a-vis the Chinese government. The market supposes that there is a significant chance that rather than duly following the prescription of the economics textbook, the Chinese government has simply lost control, with currency weakness being a manifestation of the demise.
This is perhaps understandable given the poor quality of Chinese economic data, government policy opacity and the folly of the government’s attempts to control the stockmarket since last summer, which have hurt its credibility.
That said, I do not think it is the correct interpretation of what is going on in China. The market is worried about knock-on effects of a weaker RMB on China’s trade partners. This is a more substantive concern, but markets are already braced for a poor outlook in emerging economies in the near term, on account of the slowing of Chinese growth and the tightening of US monetary policy.
With emerging markets equities at one of their cheapest ever levels in history, it is not as though the market is in need of a reality check on emerging markets.
As such, we expect to see markets negotiate this hurdle once they get better visibility concerning US and Chinese policy, and some evidence of its positive effect on the Chinese economy.
