The Macro Report | December 2016

EM weakness may spread

China continues to adjust its capital controls while political change in Washington, D.C., may signal substantive transformations of China/U.S. relations.

Aside from India, where the government has managed to cause considerable economic disruption in a botched demonetization project,* emerging economies appear on the surface to be slightly stronger to us over the previous month. But underneath some of the healthier aggregate data points on emerging markets (EM), we observe that political struggles appear to be building again in Brazil, political tensions remain high in Turkey and South Africa, and capital outflows prompted by Trump’s election victory have pushed interest rates up across almost all EM. While the economic effect of higher rates will be partially offset by the drop in exchange rates, we should expect to see at least some EM slowdowns in the coming months. In the short run, however, with China providing mild positive surprises in its data, there has been some resilience in the EM data flow.

China stays controlled

Although China’s economy has been boosted with stimulus, that stimulus is being withdrawn as policymakers work to fine-tune the economy’s growth. Overall, we do not think this experimentation will conclude well, but the end does not appear imminent. We do, of course, have the additional uncertainty generated by the U.S. election and Donald Trump’s phone call with Taiwanese President Tsai, the motivation for which is unclear. It certainly has grabbed Beijing’s attention. Will China be named a currency manipulator? If it is, how will Beijing respond?

At the moment, the yuan is weakening, and the authorities are resisting this, so if there is any currency manipulation, it is focused on keeping the yuan stronger than it would otherwise be. As our accompanying illustration shows, China’s foreign reserves position is on the decline and private capital is leaving China fairly quickly, although not at the pace of the late summer and year-end of 2015.

However, flows in and out of China are not free. They reflect what the authorities allow to happen — with some leakage, of course, to which all systems of flow controls are susceptible. On the available balance of payments data, net outflows exceeded $200 billion in the third calendar quarter of 2016, and they seem to be continuing thus far in the fourth quarter, albeit at a slightly reduced pace.

Fine-tuning China’s capital account

The Chinese authorities continue to tweak their capital-flow controls with a series of small tightening measures. Over the span of a month, they have restricted the use of Bitcoin exchanges to send money overseas, introduced new monitoring of flows through the Shanghai Free Trade Zone, restricted large overseas direct investments, and tightened the ability of onshore companies to loan yuan to offshore subsidiaries. Clearly, China has ample scope to fine-tune the nation’s capital account, just as it fine-tunes GDP growth.

However, this is all a reflection of domestic economic strains. In our view, if returns to capital within China were attractive, capital would not be leaving. But returns on capital in China cannot be pushed higher because that would restrict credit creation as well as growth, and would impose high costs — probably unbearable ones — on domestic debtors.

We continue to think there is a big problem building in China, particularly in its towering debt, but we also think the authorities have the tools and the determination to keep everything running, if not actually making much progress. At the margin, there is a risk that the yuan will be weaker and growth slower in 2017, perhaps significantly more so than expected.

* The Indian government recently decided to demonetize the two largest currency notes in circulation, the 500 and 1,000 rupee notes, and replace them with new designs. The key to doing this sort of thing well is to ensure there is a plentiful supply of new notes, and to give people lots of time to transfer their old notes into the new ones. The Indian government did neither. In large part, this project was aimed at clamping down on the informal economy, which runs on cash. But cash is a key payment mechanism for the rest of the Indian economy, and the notes in question accounted for about 86% of all cash in circulation. In the short term, the economic costs of this badly designed and executed policy initiative have been estimated to run as high as 2% of GDP.

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