3rd June 2016
Jan Dehn, Head of Research at Ashmore, discusses how China has confounded the bears again as the bond market is opened fully. Ahead of important central bank meetings this month, Dehn looks at the complex balancing act facing the US, Europe and Japan when it comes to currencies.
Do not bet against China
China has once again confounded investors by moving faster and more aggressively on reforms than most expected. With immediate effect, the People’s Bank of China (PBoC) has opened China’s interbank bond market (CBIM) to all global institutional investors. In a sign of the seriousness of China’s intentions to incorporate its economy into global capital markets, including becoming a major global reserve currency, PBoC opened with market subject to rules that were more flexible than anticipated. Specifically, there are no restrictions whatsoever on inflows and outflows. Remittances can be in CNY or in foreign currency.
Foreigners also face no restrictions participating in both cash bonds and derivative markets, such as interest rate swaps, forward bond markets, securities lending and forward rate agreements. Quotas are entirely eliminated. In our view, this development paves the way for China’s government bond market to enter key fixed income benchmark indices this year as we anticipated in the 2016 Fixed Income Outlook. Last year’s big policy objective was to commence SDR inclusion, a process that will also be completed this year. China’s interbank bond market is more than USD 7trn in size, but foreign involvement has been limited by quotas and lack of index inclusion. These constraints are now either gone or likely to fall away soon.
China is the first Emerging Markets (EM) currency to be admitted as a global reserve currency. China is also the only large global reserve currency nation not to print money through QE programs. Unlike bonds in the other main SDR countries, Chinese bonds pay yields that are positive in both nominal and real terms (China’s core inflation rate is 1.5%). Concerns about China’s debt stock are overblown. China has large debt because it has a large savings rate, which in turn means that deposits in the banking system are high. Banks lend out the money with moderate leverage compared to Western banks. China’s debt levels are roughly similar to that of Western economies, but China has ten times higher savings.
Recent Japanese data ‘mixed’
Japan’s political leadership is once again issuing warnings about the global economic outlook. This follows further deflation in Japan in April (-0.3% yoy versus -0.1% yoy in March) and weakness in manufacturing, household spending and employment, though industrial production was better than expected. Overall, recent Japanese data can best be described as mixed. Still, it was weak enough to prompt Finance Minister Taro Aso to delay a planned hike in sales taxes and replace it with yet more fiscal stimulus, according to Nikkei, a newspaper.
Japan’s recipe of yet more stimulus has been tried before – it only pushes the government even further into debt. Policies of fiscal and monetary stimulus and ignoring structural reforms are policies that are being followed right across the developed world. So far, they have not worked, yet no one is seriously considering alternative approaches.
It is important to keep a close eye on Japan’s predicament, because Japan is so much further down the road of unconventional policies than other Western crisis economies. Right now Japan is clearly finding it impossible to reform and impossible to remove stimulus for fear of the short-term economic consequences. The worry is that Japan’s situation is not dramatically different from the situation in the other developed economies. In Europe, bond yields are so low that even the risk of materially higher bond yields would probably elicit further bond purchases by the ECB.
Fed hike probability has gone up
In the US, the probability of a Fed hike has gone up following Fed Chairwoman Janet Yellen’s comments to the media last week. The odds of a June hike are now 30% and 54% for July. Our view is that the Fed’s ability to tighten monetary policies meaningfully in real terms is constrained by elevated asset prices, high debt levels, terrible productivity, a poor earnings picture and an overvalued USD. If inflation rises the Fed can hike without tightening in real terms. The US has an important advantage over Europe and Japan – it has better odds of being able to generate inflation. The US can also weaken its currency, since the US dollar is up 40%-50% versus most currencies in the world, including the EUR and JPY. A weaker USD would materially help the US economy by easing pressures on shale, manufacturing and exports. Unfortunately, inflation expectations are declining right now, which is why the combined odds for June-July is still for the Fed to stand pat.
If the US eventually manages to inflate and weaken its currency both Europe and Japan will find themselves in a spot of bother. Neither is in a position to handle stronger currencies. How, then would Europe, Japan and the US work out their little currency predicament? In the short term, there is likely going to be a strong desire on the part of all parties to maintain their currencies within relatively narrow ranges. This seems possible, because neither the US, Europe nor Japan seem likely to experience major economic shocks in the very near term.
However, eventually something will shatter the detente. At some point inflation and/or recession becomes inevitable, even if their timing is currently uncertain. If recession hits, a policy response will naturally be required. And the only remaining policy options are negative interest rates and Helicopter Money. Both would have big impacts on currencies. If, on the other hand, inflation becomes a problem then this too would challenge the monetary authorities due to stretched economic and financial conditions. Forced to choose between disinflation and growth – having both at the same time seems impossible due to low productivity – the monetary authorities would likely opt to protect growth. Again, there would be serious spill-overs to currencies.
EM would welcome stronger currencies
In contrast with Europe and Japan, EM countries would generally welcome stronger currencies. The last few years of USD strength precipitated a giant global portfolio shift, whereby global asset allocators took additional exposure in the QE markets, which they financed by reducing exposure to non-QE markets, including EM. While challenging at first, the resulting weaker EM currencies and higher domestic yields eventually helped to restore EM external competitiveness. This is now evident in much-improved external balances. Rising EM currencies would take back some of this competitiveness, but also bring in fresh capital inflows, which in turn would finance consumption and investment leading to stronger growth.