24th March 2015
Ashmore head of research Jan Dehn looks at why China is driving for an ever more prominent role in the global financial system…
The support for its Asian Infrastructure Investment Bank initiative directly challenges the old Bretton Woods institutions and rightly focuses on the single most important constraint to continued Emerging Markets (EM) expansion – developing domestic infrastructure which has failed to keep pace with private sector expansion. China has also taken a significant step by allowing local governments to convert or issue RMB 1.5trn of debt and become a key element of the country’s debt markets. We also review Brazilian politics and Russia’s economy, which is now adjusting to the policy changes of a few months ago.
China continues to aggressively position itself for a much more prominent role in the global financial system. In the past few weeks, it has won notable support for its own Asian Infrastructure Investment Bank (AIIB) initiative, which directly challenges the influence of the IMF and World Bank. This is not ‘first-best policy’, but China is right to pursue this approach anyway, because the first-best policy is not available given opposition by the largest developed economies, notably the US, to reform of the Bretton Woods institutions.
The single most important constraint to continued EM expansion is not external in nature – rather it is domestic in the shape of inadequate infrastructure. The private sector in most EM countries has expanded dramatically in recent decades, but the public sector’s ability to expand infrastructure has not kept pace. Also, financial repression and regulatory measures imposed by Western governments have largely made it impossible for institutional investors to channel sufficient funding into EM infrastructure. It appears obvious that the greatest possible boost to global demand and therefore global growth would be unleashed by removing the supply constraints that are the cause of inadequate infrastructure in EM today. As such, China’s aggressive policies to expand investment in infrastructure are positive – and are largely being welcomed by most countries.
Another major development in China deserves mention. In a move that will significantly expand the size of the tradable local government universe of fixed income stocks, the Ministry of Finance has granted permission for local governments to convert RMB 1trn of existing debt to bonds. This refinancing operation should ease concerns of those who fear that local governments could not refinance the debt they issued in recent years. This is not net issuance, but as part of the budget the government will also issue RMB 500bn of scheduled new issuance of local government debt in 2015. This will include 1 and 3 year maturities that will now be added to the existing benchmark maturities of 5, 7 and 10-year bonds. We think the Chinese local government bond market will grow to become a central element in the Chinese fixed income universe, akin to the municipal bond market in the US.
The popularity of President Rousseff declined to 13%, close to all-time historical lows for a sitting president in Brazil’s democratic era. This follows widespread popular protests against the government in the streets of major Brazilian cities this month. But it is not all bad for President Rousseff. Despite the poor sentiment among the electorate, the political environment seems to be improving at a parliamentary level. The main coalition party, PMDB (which controls the lower house, the upper house and vice presidency) is on better terms with the workers party after the President fired the education minister who was causing trouble within the coalition.
Also, importantly, the government managed to obtain approval for the 2015 budget, which locks in the fiscal adjustment proposed by Finance Minister, Joaquim Levy. Also positive was the fact that a vote on tricky legislation which could have resulted in increases in public sector pensions was postponed. By maintaining good relations in parliament, President Rousseff can stave off the threat of an impeachment process against her, which could pose a real threat to the ongoing (and absolutely necessary) fiscal adjustment. In any case, an impeachment process needs approval by both houses plus the Supreme Court and it would not necessarily help the opposition as the PMDB party would still keep the upper hand in terms of deciding political succession. President Rousseff’s troubles emanate from the corruption scandal at Petrobras, which remains the main macro risk.
However, the first milestone is rather banal – namely publication of audited numbers. It is likely that these numbers will be forthcoming. Fitch mentioned in a call this week that if Petrobras avoids breaking covenants Brazil would likely keep its Investment Grade status for now. Meanwhile, all this political noise has been bad for capital flows. With no new debt issuance ytd due to the Petrobras mess and no significant inflows from foreign investors due to the strong USD environment, local hedge funds and corporate FX hedging outflows have been dominant, which has put the BRL under intense pressure. The central bank has announced it will stop underwriting new FX Swaps at the end of this month, thus only rolling over the existing stock of approximately USD 110bn. This makes a great deal of sense. The existing swaps program is large enough to provide hedges for corporations and investors with liabilities in USD.
The BRL weakness has helped to push inflation well above the central bank’s target in March – the IPCA-15 index pointed to 7.9% yoy inflation. President Rousseff’s problems are entirely self-inflicted. Given the evident need for further tightening of both fiscal and monetary policies alongside the continuing sordid saga of Petrobras, it will clearly be some time before President Rousseff’s political fortunes turn for the better.
The effects of rate hikes and the weaker Russian Ruble are now beginning to have a significant effect on economic activity. Retail sales in February declined by 7.7% yoy and real wages were down 9.9% yoy. Unemployment rose marginally and both fixed investment and industrial production declined. This is no surprise. Domestic demand is bound to fall in response to the large devaluation of the RUB and higher interest rates.
This domestic adjustment complements the external adjustment via the currency and should ensure that Russia’s current account delivers a decent surplus this year despite lower oil prices. Hence, the pain for Russia’s consumers is ultimately necessary to preserve macroeconomic stability in Russia by ensuring that the country continues to live within its means even with a lower oil price environment.
Against this backdrop the RUB is slowly recovering. Having traded close to 70 in January, USDRUB last week broke below 60. Meanwhile, more and more officials are beginning to link a dismantling of Russian sanctions with a sustainable peace accord for Eastern Ukraine. This makes sense: the annexation of Crimea by Russia triggered sanctions from the West, which in turn led to Russian meddling in Eastern Ukraine. Thus, a deal between the West and Russia was always going to have to involve discussion of sanctions in connection with the question of a peace settlement in Eastern Ukraine.