In the medium to longer term, lower oil prices and a weaker Chinese yuan are positive. In the short term, however, these moves are causing volatility as they are far from gradual.
Will we still see moves of a similar magnitude?
Markets scared by yuan depreciation and falling oil price
At the start of 2016 we have once again seen movements in financial market prices that have induced a sharp increase in investor risk aversion. The situation brings back memories of August 2015, when we saw a quite similar picture. The most important price moves are the yuan exchange rate depreciation and the sharp decline in the oil price. In general, the direction of these moves is either desirable or a long-run positive for global growth. Still, it is clear that in the short term, negative spill-overs to localized areas in credit space (e.g. High Yield and EMD) have the potential to induce a general rise in risk aversion – especially when these moves occur at high speed.
Starting with the yuan it is clear that the Chinese economy is in the midst of a delicate rebalancing phase, moving away from a reliance on investment and heavy industry output towards more consumer spending and service sector output. At the same time, the country is gradually liberalizing its financial system amidst a still rising trend in private debt as a percentage of GDP. A gradual currency depreciation is then desirable as it will allow Chinese monetary policy to decouple from US monetary policy while at the same time providing additional demand support through the positive effect on exports.
Still the word "gradual" is the really operative word here. First of all, yuan depreciation can increase Chinese policy uncertainty by strengthening the perception that policymakers are incompetent, especially in light of how they handled the turmoil on the Chinese equity market. On top of this, rapid depreciation will hurt many Chinese companies because of the US dollar-debt on their balance sheets. Also, gradualism is desirable because the yuan/dollar exchange rate acts as a sort of focal point for EM depreciation expectations in general. In this sense rapid yuan depreciation may release the “EM depreciation genie”. If this happens it could be pretty disruptive as the driving force behind this depreciation, i.e. massive capital outflows, will tighten EM domestic financial conditions and credit supply. In theory, the balance of these two forces (exchange rate depreciation and tighter domestic financial conditions/credit supply) will exert an ambiguous effect on growth. In practice, one can safely assume that for many EM countries the net effect will be negative.
Lower oil prices unambiguously positive in the medium term
Meanwhile, the decline in the oil price means a further deterioration of the terms of trade for commodity-producing countries, which has led to a further deprecation of their currencies. As always, this also has the potential to spill over to EM currencies in general. In addition, investors may well see the fall in the oil price as a signal of a further fall in EM demand growth in particular and global growth in general. This perception is expressed in rising levels of global risk aversion.
The question is whether this perception is justified. We believe it is not, as the decline in the oil price seems to be largely related to the fact that the supply side of the oil market is not yet adjusting to the new reality in the way assumed a few months ago. This was very much the message that came out of the December OPEC meeting. In fact, in the medium term, lower oil prices should be unambiguously positive for global growth as it is a transfer of income from savers to spenders. In this respect, it will also help to alleviate the global savings glut which is holding down global neutral real rates (i.e. real rates consistent with full employment). Despite this, we do recognize that the path from the short to the medium term may be a volatile one with several pitfalls on the way.
In this respect it is important to remark that next to the change in the oil price, its absolute level matters as well. The latter is a crucial determinant of the incidence of bankruptcies in the energy sector and fiscal sustainability in the oil-producing EM countries. In combination with the aforementioned global growth worries fuelled by falling oil prices, all this has the potential to put global risk appetite on a negative bandwagon that can create its own negative growth reality if left unchecked.
Stabilisation in oil and exchange rates seems a precondition
The big question is thus if and when this negative bandwagon will be stopped. To get some kind of grip on this question we compare the situation to the experience of August 2015. Stabilisation in global risk appetite will be difficult to obtain as long as there are still sharp movements in oil and exchange rates. Starting with exchange rates, the dollar appreciation since mid-2014 clearly acted as a catalyst for the August 2015 turmoil because of EM reliance on dollar funding. We think we are unlikely to see a repeat of the 20% rise in the trade-weighted US dollar over the past 18 months. Back in August, the stabilization in the yuan-dollar exchange rate arguably played an important role in restoring sentiment. For now it is still an open question how far China will allow the yuan to depreciate against the dollar. As far as oil is concerned the movements seen between June and August as well as between late October and now are more or less similar (around 30% down). Another move of similar magnitude does not seem likely but we may not have seen the bottom yet.
Global economy has so far been resilient
The strength of EM and global economic momentum heading into the financial market turmoil is clearly very important. In this respect, several indicators of EM momentum suggest that it is at a somewhat better level than seen back in August. At any rate, the global PMI has remained in a pretty narrow range since the spring of last year, after a moderate decline from the levels seen in early 2015. As such, the PMI continued to indicate global growth in the 2.5%-3% range over the nine months to December. An important lesson from the August turmoil is the resilience of DM space with respect to weakness in EM space and the rise in global risk aversion. Business and consumer confidence was hardly affected by all this (especially so in Europe) which resulted in a general continuation of positive trends in hiring and consumer spending data.
Still no pressing need for China to start deleveraging
China is clearly at the epicentre of EM in many respects. Not only is it the largest EM economy but it is also by far the biggest driver of the increase in the EM debt pile. The combination of slowing growth momentum and a rising debt-to-GDP ratio would suggest that the need to start deleveraging actively should become more pressing over time. At some point it probably will but we may still be a few years removed from that. It seems that the Chinese authorities are willing to kick the debt can down the road for a while yet. After all, China does not depend on foreign funding. It also has a large pool of FX reserves which it can use to manage the exchange rate, ongoing capital controls and ample liquidity/recapitalizing tools to support the domestic banking system.
Adding it all up, at this point in time the situation looks less severe than it was in August, although the wild cards reside very much in EM space where a mix of self-fulfilling processes and policy mistakes could make matters much worse than in August.