May-June 2010
Return to: Our market viewA Question of Balance
Global financial markets are in turmoil again. To a large extent, this is the result of economic imbalances caused by a fundamental change in the dynamics of capital flows. These imbalances have long been in existence but they have intensified in the wake of the recent financial crisis. If unchecked, they have the potential to undermine the nascent global recovery.
A glance at where global growth is concentrated in today’s world reveals a development that confounds the post-war economic experience. Many emerging market economies are booming, while their more developed counterparts are eking out minimal growth rates as they continue to labour under massive debt burdens. This burgeoning trend has little to do with the relative immunity that emerging markets had during the financial meltdown, nor is it the result of better-executed fiscal and monetary policies. Rather, it is due to the global movement of capital.
Most emerging markets, while no doubt grateful for the growth that these capital inflows have engendered, are aware of the longer-term potential inflation threat arising from them. China, India and Indonesia have already taken steps to avert this outcome by tightening monetary policy. However, with the western economies likely to maintain a very loose monetary policy for some time to come, this has led to further capital inflows into emerging markets due to their favourable interest-rate differentials. Latterly, fears of contagion in Europe of the “Greek disease” have also played their part in this development. The situation has been further exacerbated by the relative inflexibility of emerging market currencies, which have not strengthened significantly despite the amassing of huge amounts of foreign reserves by the countries concerned, and have thus retained their attractions for overseas investors.
Chinese boxes
The key to resolving this conundrum is China’s exchange rate, which remains fixed. As there is fierce competition for trade in the region, allowing currency appreciation is a no-go area for most Asian states, while capital controls in one country simply divert capital flows elsewhere. China has signalled that it realises the scope of the problem that global imbalances are causing, and has intimated that it will make the renminbi more flexible at an as yet unspecified point in the future. Without any official, supranational regional body to oversee and co-ordinate this, it is likely that behind-the-scenes negotiations between China and other Asian governments and central banks will result in these countries following suit to ensure that any competitive advantage in exchange-rate terms is kept to a minimum.
However, given China’s reluctance to act quickly and decisively, there is a substantial risk that the situation may spiral out of control. Small, gradual adjustments to Asian interest rates will have a correspondingly minimal impact on exchange rates, and this will therefore have a minor and temporary affect on overall global imbalances. Only a major policy offensive by China to address this issue will bear fruit in time.
Silver lining
Ironically, the Chinese pictogram for crisis is composed of two elements: danger and opportunity. While China continues to ponder its pivotal status in the resolution of the challenges posed by global imbalances, there will be beneficiaries of the ongoing turbulence in the foreign exchanges. The post-Greece slump in the euro, for example, could not have come a better time for eurozone exporters, particularly in Germany, whose export prowess has seen it weather many an economic storm.