Don’t blame China for emerging market wobbles

It’s no surprise the jump in yield from China’s benchmark 10-year government bond – 4 per cent for the first time since September 2014 – and the central bank’s injection of US$47 billion into the financial system have been viewed as a sign of a serious deterioration in sentiment towards emerging markets

PUBLISHED : Monday, 20 November, 2017, 10:41am
UPDATED : Monday, 20 November, 2017, 10:33pm

The surprise 2 per cent devaluation of the yuan on August 11, 2015, is an event which still sends shivers down the spines of emerging market investors – and with good reason.

Fears about a significant slowdown in China’s economy and concerns about the credibility of the country’s policy regime led to a sharp sell-off in emerging market assets.

The MSCI Emerging Market Index, the leading equity gauge for developing economies, plunged nearly 18 per cent between early August 2015 and mid-January 2016, while money gushed out of emerging market bond and equity funds, resulting in net outflows of nearly US$80 billion for the whole of 2015.

So it is not surprising the jump in the yield on China’s benchmark 10-year government bond, which last week touched 4 per cent for the first time since September 2014, and the central bank’s injection of US$47 billion into the financial system – the largest intervention since mid-January – have been seized on by market commentators as a sign of the seriousness of the recent deterioration in sentiment towards emerging markets.

China’s crackdown on debt-financed growth, coupled with signs that policymakers’ deleveraging campaign is dampening economic activity and putting China’s bond market under strain, are being viewed as the catalyst for the recent price declines in emerging markets.

The Shanghai Composite is currently higher than where it stood a month ago (and is still up nearly 10 [er cent since mid-May), China’s capital flow was positive in the first half of this year, and the yuan is up more than 4.5 per cent against the dollar since the start of 2017

That the sell-off is occurring amid falls in China-sensitive commodity prices, particularly industrial metal prices, is reinforcing the perception that China is mostly to blame for the current jitters in emerging markets.

There is no question that sentiment towards developing economies has taken a knock over the past several weeks.

According to JPMorgan, the average spread on emerging market dollar-denominated bonds is up 15 basis points over the past month while the average yield on local currency emerging market debt has risen nearly 20 basis points.

Emerging market equity and local currency bond funds are suffering outflows while many countries’ currencies have fallen sharply, with the Turkish lira, South African rand and the Brazilian real down 13.5 per cent, 7.7 per cent and 5.5 per cent respectively against the dollar since early September.

Moreover, the spectacular rally in emerging market stocks – which have generated returns of 32 per cent this year – has faded, with developing economies’ equity markets standing more or less at the same level as they did in mid-October.

Yet does the deterioration in sentiment stem from developments in China and, if so, should parallels be drawn between the current wobbles in emerging markets and the 2015 China-led sell-off?

First of all, the jitters over the past few weeks are a far cry from the dramatic price declines which followed the 2015 devaluation, which were exacerbated by the frantic attempts by Chinese policymakers to prop up the country’s free-falling equity market.

The Shanghai Composite is currently higher than where it stood a month ago (and is still up nearly 10 [er cent since mid-May), China’s capital flow was positive in the first half of this year, and the yuan is up more than 4.5 per cent against the dollar since the start of 2017.

Just as importantly, sentiment towards other markets in emerging Asia – the most vulnerable region to a China-induced sell-off – remains positive.

The jitters over the past few weeks are a far cry from the dramatic price declines which followed the 2015 devaluation, which were exacerbated by the frantic attempts by Chinese policymakers to prop up the country’s free-falling equity market

Over the past month, the Malaysian ringgit, the Korean won and the Thai baht have all risen against the dollar. Last week, Moody’s, the rating agency, raised India’s credit rating, causing the rupee, India’s currency, to strengthen further.

Make no mistake, it is not fears about China’s economy that are the main source of the recent strain on emerging market assets.

Other factors have been more important in influencing sentiment towards developing economies.

The most important one, as I explained in a column last week, is a growing sense among investors that the rally in so-called risk assets has gone too far.

It is not just emerging markets which are under pressure. The frothy US high-yield, or “junk” bond market, is under heavier strain and last week suffered the largest weekly outflows in three years. All major global equity markets also suffered declines last week.

Just as importantly, market volatility has fallen to such low levels this year that even fairly modest sell-offs – despite the recent outflows from emerging market funds, inflows into the asset class this year stand at nearly US$175 billion, close to the record high for the whole of 2010, according to JPMorgan – are considered a major event.

There should be no complacency whatsoever about China’s severe financial and economic problems. But neither should market commentators blame China for the recent print declines in emerging markets which, in any case, are being treated as a buying opportunity by most investors.

Nicholas Spiro is a partner at Lauressa Advisory

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