Don’t count on China’s economic stimulus to rescue emerging markets this time

For the first time since the sell-off in emerging markets deepened in April, a growing number of investors and analysts are starting to talk about a loss of confidence in the asset class.

One of the main determinants of whether the emerging market sell-off will intensify in the coming months and whether the stresses in the asset class will spill over into advanced economies, in particular the United States, is China. While the world’s second-largest economy accounted for just 3 per cent of global gross domestic product during the 1997-98 Asian financial crisis, it now constitutes 15 per cent and generates one-third of global growth, according to data from the International Monetary Fund and the World Bank.

Moreover, the China-induced sell-off following the surprise devaluation of the yuan in August 2015 provided a foretaste of what could lie in store for global markets if concerns about China’s economy and policy regime become much more pronounced. One of the reasons why markets – both in China and abroad – recovered in 2016 was the beneficial effects of the stimulus measures introduced by Beijing to avert the risk of a hard landing in China’s economy.

China implemented two major stimulus programmes, in 2011-12 and 2015-16, following its 4 trillion yuan (US$583 billion) mega-stimulus package in 2009 which helped rescue a recession-plagued global economy. Some investors are again looking to China to provide the circuit breaker to prevent contagion across emerging markets from spiralling into a wider conflagration.

Beijing’s recent shift towards more growth-supportive policies, aimed at forestalling a sharper slowdown amid a rapidly escalating trade war with America, is cited by some investment strategists as a possible catalyst for a marked improvement in sentiment in the coming months.

While policy activism in China has proved to be a potent source of support for markets in the past, the “Beijing put” – the term often used to describe investor expectations that policymakers can be relied on to prop up the economy and markets if growth declines sharply – is not the answer this time around.

China’s economic struggles aside, emerging markets aren’t faring so badly

First, China’s current stimulus measures are much more modest than in previous easing cycles and, although possibly a prelude to more forceful steps later on, they are constrained by the deleveraging campaign. The relaxation of monetary and fiscal policy is tempered by much tighter regulation of the financial and housing sectors.

While looser fiscal policy should help reverse the steep decline in infrastructure spending in the first half of this year, the easing is mostly a reversal of the excessive tightening earlier this year rather than a burst of fresh stimulus.

Second, as JPMorgan notes in a report published in late July, while China’s two previous stimulus packages sparked rallies in markets – measured by the performance of Chinese and emerging market equities as well as metals and mining stocks – the upturn petered out after three months.

“This time around, rebounds will likely prove [even] more limited than in previous episodes”, partly because deleveraging remains a long-term objective but also because emerging market share prices are higher than they were in 2011 and 2015, the report notes. Indeed, since policymakers ramped up their efforts to stimulate China’s economy in late July, the MSCI Emerging Markets Index has dropped a further 6.5 per cent.

Third, as I have argued in previous columns, the strain on developing economies stems mainly from this year’s tightening in financial conditions, led by the surge in the US dollar. Even a more aggressive Chinese stimulus package is unlikely to offset the effects of tighter liquidity, which is mostly attributable to the buoyancy of America’s economy.

Donald Trump won’t like it, but a strong US dollar reflects a weak yuan more than American economic strength

The policy signals from the Federal Reserve, which is set to raise interest rates for the third time this year later this month as it continues to unwind its bloated balance sheet, have a stronger bearing on emerging markets right now because of the strength of the US economy.

Concerns that the Fed will continue to play down the sell-off in developing economies and tighten policy further are increasing the pressure on the asset class.

Still, while financial instability in China forced the Fed to put off a rate hike twice in the past three years, the yuan has stabilised in the last month and there is no sign of rampant capital flight of the kind that occurred in 2015-16.

The Fed will be reassured that emerging market dollar-denominated bond spreads are still below their average levels since 2010, according to data from Bloomberg, suggesting that investors are not too concerned about China for the time being.

If markets are taking the financial turmoil in China in their stride, there is even less of a reason for investors to look to Beijing to provide the catalyst for a recovery in emerging markets.

Nicholas Spiro is a partner at Lauressa Advisory