Can emerging stock markets underperfom?

January 10th, 2010

Share |

We have covered China in our previous two articles (Hazard ahead for Australia- interim crash in China and Chinese government cornered by inflation, bubbles & rich-poor gap). Following them, we will look at the implications for the financial markets today. This should not be interpreted as ‘predictions’ of what will happen in the financial markets. Rather, they should be seen as issues for investors to consider. Since we are delving into a complex area, we do not pretend we will get everything right here.

Firstly, as we wrote before in Chinese government cornered by inflation, bubbles & rich-poor gap, China will eventually have to tackle their inflation problem. The longer they delay tackling this issue, the bitterer the medicine will be when they have to do it. We are sure the Chinese government understands it and they are probably debating among themselves in their inner sanctum.

In the meantime, there’s a potential danger that can throw the spanner into the works- trade war with America and Europe. The sticking point is the value of the yuan. By keeping their currency undervalued, the Chinese are exporting their goods to America and Europe while the latter export their inflation back to China. The popular sentiment among many in these Western nations is that China is contributing to higher unemployment in their countries. Already, we are frequently reading news report of initiation (and retaliation) of trade restrictions between the two sides. In a sense, low-level trade wars (“skirmishes” is a better word than “war” in this context) are already happening.

To their credit, the Chinese are doing something about this. They are expanding their trade ad investment relations with the rest of Asia, Africa, Middle-East and South America. This means that with each passing day, trade relations with Europe and America will become less and less relevant, which means that China will become less and less reliant on their currency peg to maintain the status quo in their economy. As we wrote before in Rumours of China diversifying their US dollars,

Not only that, the Chinese are setting up currency swap agreements with their trading partners [mainly with the non-Western nations] so that their yuan could be directly used for trade instead of using the US dollar as an intermediary.

This is another example of what the Chinese are doing to make the US dollar less relevant. If the Chinese can trade more with the emerging nations in their own currency, then the currency peg with the US dollar will become less and less necessary. Not only that, this will give China the prerogative to export inflation to other countries (as the US is currently exporting inflation to China- see Why is China printing so much money?).

The risk is that before the Chinese long-term plan can bear fruit completely, trade war erupts between China and America/Europe. Of course, both sides will suffer in such an eventuality, which is a reason to believe that they would not want that to happen. But our suspicion is that China may suffer a bigger pain initially. The reason is because, as we wrote before in Can China really ?de-couple? from a US recession?, the fall in Western consumption has a leveraged effect on China’s economy.

To compound China’s problem, in such a context, our guess is that the US dollar may devalue, which means China’s US$2 trillion kitty of currency reserve will lose its purchasing power. This is because the US current account deficit will shrink significantly, which means China’s purchase of US government debt will shrink as well. That in turn will be less supportive of the US dollar. Also, the spigot of Chinese imports will dry up, which will translate to price inflation in the US. In a way, with commodity prices in its up-trend once again (e.g. copper prices is back to the pre-GFC level), China’s kitty is losing purchasing power once again.

In such a scenario, stocks in the emerging economies may actually perform worse than American stocks. In the Panic of 2008, as the Chimerica imbalance unwind with a big bang, emerging market stock markets fell much more than their American counterpart. The 2009 ‘recovery’ winds up the imbalance once again. Therefore, should the imbalance unwind again (e.g. due to rising trade tensions, major economic correction in China, Chinese government clamping down on inflation), it is possible that we will see history repeating itself once again.

Tags: ,