In the post-financial crisis period there have been two pillars of support for emerging markets and economies – and the Australian dollar. With one now being progressively withdrawn, albeit at a leisurely pace, and a question mark over the other’s stability, it isn’t surprising that markets in 2014 have been enveloped in volatility.
While much of the post-GFC period’s Australian dollar strength and emerging markets growth has been related to the growth in China’s economy, their buoyancy has also been under-pinned and inflated by the US Federal Reserve’s $US3 trillion quantitative easing program.
The dollar and emerging markets were rattled late last week when the latest China Purchasing Managers Index was weaker than expected, suggesting a slowdown in China’s economy.
There are also growing concerns that China’s shadow financial system could be on the verge of a meltdown, with the potential for defaults of trust entities within that system later this month triggering fears of broader stress within the system.
Given that most developing economies’ activity – and the now-waning resources investment boom in resources economies, including Australia’s -- since the crisis has been under-pinned by the growth in China’s economy, any instability or slowing has obvious negative implications.
Those would be exacerbated by the ‘tapering’ of the Fed’s quantitative easing program. Last month the Fed began the taper by announcing it would trim $US10 billion a month from its $US85 billion a month bond and mortgage-buying program.
Perhaps surprisingly, given that the merest hint of tapering had previously created turmoil in emerging markets, that announcement was initially digested with relative equanimity by markets.
Subsequently, however, there have been capital outflows from Asian, South American and other developing economies, with significant impact on the value of their currencies. In the past fortnight, the Australian dollar has fallen from its high of US91 cents this month to trade below US87 cents.
The Fed’s Open Market Committee meets again this week and there appears to be a widespread expectation that, rather than sit back and watch for the impact of the initial taper, it will cut its program by another $US10 billion a month.
While still pumping liquidity into the US economy, another reduction in the program would be a signal of clear intent and direction and the not-too-distant end of the program would be in sight. The Fed has, of course, made it clear that it will still hold US short-term rates close to zero until the US unemployment rate falls below 6.5 per cent.
It has always been impossible to tell how much of the liquidity created in the US and, more recently, in Japan has flowed into emerging markets or into higher-yielding carry trade plays like Australian dollar assets. The sensitivity of the dollar and developing economy currencies to speculation about the future course of the Fed’s program, however, has suggested very substantial capital flows.
Earlier this month the World Bank warned that capital inflows to developing countries could shrink by as much as 80 per cent in a concentrated period if central banks unwound their expansionary programs.
That would, obviously, cause turmoil in currency markets but would also likely see interest rates spike and economic growth built on the easy access to cheap funds unwound. It could be very destabilising for those countries with large current account deficits, particularly if the big capital inflows of recent years have been used unproductively.
If a continuation of the Fed’s taper coincided with a clear slowdown in China’s rate of growth and, perhaps, the bursting of the apparent bubble within its shadow financial system, there could be some nasty outcomes.
While the Reserve Bank might not be too concerned about a controlled devaluation of the Australian dollar, which is what it has been seeking, it wouldn’t want to see it in freefall, would be concerned about the prospect of inflation being rekindled and would be mindful of the wealth and psychological effects if a surge in capital outflows pulled the rug from under asset prices.
Any significant disruption to China’s growth or financial stability would also, obviously, add another significant layer of challenges to the resources sector, which is relying on volume growth to offset the decline in prices while trying to reverse the substantial escalation in costs that occurred during the boom years.
With little prospect that the US recovery that has emerged will accelerate to the point where it offsets a slowdown in China, or that the eurozone will generate anything but weak growth at best, what happens within China over the course of this year is significant, not just for the region, but for the global economy.
In the long term, bringing its shadow financial system under control and imposing greater discipline on investment within its economy could be tremendously positive for the Chinese and the rest of us.
In the near term, however, the question mark over China and the coincidence of the Fed’s likely continuing tapering of its quantitative easing program casts its own shadows over markets and economies.