Emerging Markets Weekly

Investors concerned about how U.S. government and central bank policies will affect emerging markets over the next few years are focusing on the potential side-effects of these policies on the U.S. dollar.

Trillions of dollars in additional government expenditure will likely lead to higher bond yields and a weaker dollar necessary to finance the U.S. budget deficit. This will lead to higher commodity prices. Moreover, expansionary monetary policy by the U.S. Federal Reserve Bank will also have repercussions for the dollar in that dollars will leak out the trade account and cause the currency to depreciate over the long term.

1) Commodity price effects:
Since commodity prices are priced in U.S. dollars, a weaker dollar leads to higher overall demand for commodities and higher commodity prices. Therefore, a weaker dollar benefits energy exporters such as Russia where government finances and exports are tied to oil and gas prices. In fact, there is a very high correlation between oil prices and the level of Russia’s stock market.

Investors can expect that a weak dollar will benefit Russia most out of the four BRIC nations due to its effects on commodity prices. The terms of trade shock will also coincide with a higher value for the ruble. Brazil, also a commodity exporter, is also expected to benefit from this phenomenon.

India, on the other hand, is a commodity importer. The government subsidizes the price of oil and fertilizer which are major budgetary expenses. Therefore, a falling dollar could be most detrimental to India’s budget and hence its economy and its currency.

A weak dollar and rising commodity prices are also inflationary. In the current economic environment, characterized by rising unemployment and idle machinery, the likelihood of sustained inflation is highly unlikely. However, over the long term, rising inflation is a likely outcome.

2) Export effects:
A weaker dollar caused by inflation in the U.S. leads to higher import prices and eventually to a substitution effect of domestic consumption for foreign imports. This will only happen after the U.S. trade deficit rises as expansionary monetary policy increases U.S. imports. In other words, it will correct for a rising U.S. current account deficit.

Over the long term, the effect of a weak dollar and inflation are therefore detrimental to export-dependent nations. However, China has largely pegged its currency, the RMB, to the dollar allowing for mild appreciation on a long term basis. Therefore, a fall in the dollar will not necessarily cause a serious impact on imports from China, assuming the fall in the dollar is orderly, and will certainly be mild in comparison compared to the effects of the U.S. credit crisis on China's economy.

Emerging Markets Weekly

The meeting of the leaders of Brazil, Russia, India and China in Yekaterinburg Russia last week for their first ever BRIC summit happens at a time of relative strength for this group amidst the global economic downturn. China leads the pack with continued signs that its economy is responding well to government stimulus efforts.

This week the IMF upgraded its outlook for growth in China this year and next on signs that its economy is growing, 7.2 percent in 2009 and 7.7 percent in 2010. Infrastructure and other government-influenced investment increased an estimated 39 percent in the first four months of 2009. Consumption is also reported to be strong with car sales rising 14 percent on a year ago in January to May. Yet exports were down 20% on a year ago between January and May demonstrating that China’s economy can grow without contribution from the trade sector.



China’s strength is also being felt globally in commodity markets for example where China is the only country driving demand and prices for oil and industrial commodities higher. Also in trade, China is making an impact, and is now the biggest destination for Brazilian exports. The aforementioned rise in auto sales will place China first in auto sales in 2009 ahead of the U.S., more than five years ahead of forecasts from as recently as last year.

The BRIC summit is important because it is the start of a coordinated effort by the BRIC nations to effect change on the global economic order. The four nations control more than US$3-trillion in foreign exchange reserves the bulk of which are denominated in US dollars, and they are letting it be known that they wish to reduce their reliance on the US dollar.

Most recently China has arranged currency swaps with many nations to allow foreign trade to be conducted in RMB rather than dollars. It has also allowed foreign banks to launch international bonds denominated in RMB and now allows cross-border trade in five Chinese cities to be conducted in RMB. Finally, China also announced recently that is has increased its gold holdings by 76% since 2003 to become the fifth largest holder of gold.

The rise to prominence of BRIC nations was brought forward due to the global credit crisis and their sphere of influence in the global economy will only rise in prominence over the next several decades.

Emerging Markets Weekly

The steady stream of data coming out of China continues to point to economic expansion. Industrial production in May increased 8.9% from 2008 and retail sale rose 15.2% from the previous year.

The economic expansion is being funded by very strong loan growth since the start of the year to coincide with the government stimulus package. Total lending for the first five months of 2009 totaled Rmb5.8-trillion (US$850-billion) in excess of the Rmb 5-trillion government targets for the entire year.

Investors and analysts concerns that China cannot grow without the contribution of net exports are misplaced. China indeed developed an enormous trade and current account deficit in recent years worth roughly 11% of GDP in 2007; nevertheless, domestic factors accounted for the majority of economic growth between 2000 and 2007 for example.

China’s economy expanded at close to 10% per year on average between 2000 and 2007, and net exports contributed only 1.2% of that growth. Investment accounted for 4.5% of growth and private consumption contributed 2.9% in annual growth.

Trade data—both imports and exports—continue to be weak, falling again in May, but this is a reflection of the decline in global trade rather than weakness in China’s domestic economy. A fall in exports is likely to coincide with a fall in imports since the latter are an important component of the former in China.

The end result is that China’s economy can grow with or without the rest of the world. It will likely grow at a rate below the 10% average over the past two decades, but weak trade is not devastating to China’s economy.

Emerging Markets Weekly

Recent data from India and China signify that fiscal and monetary stimulus in China and India is working and that economies are expanding. The Purchasing Managers Index in China rose for a third straight month in May indicating that the manufacturing sector is expanding. Most notably, the new export order index signaled expansion.

In India, GDP data for the fourth quarter 2008 indicated that India’s economy grew more quickly than originally anticipated at the height of the global economic crisis. Economic output in the fourth quarter was reported at 5.8% with a healthy shot in the arm from government spending. That factor and the recent favourable election results for India’s Congress Party has induced capital back to the region—US$5-billion in a single month—and sent the stock market soaring.

Positive data and rising stock markets tend to beget more capital inflows and higher economic growth as a result—especially since capital outflows were the primary cause of the economic downturn especially in India. Investors should expect positive revisions to India’s GDP numbers this year and next over the coming weeks and months.

The positive economic data has reignited discussions of economic decoupling in India and China . Without wading into the debate, suffice it to say, that the economic growth and return to profitability has more justification in these two countries than anywhere else in the world.

The developed economies are likely to recover later this year or early next year. As the dust settles it will become apparent that the recovery will be weak and that will have repercussion for emerging markets. That said, investors are realizing that the selloff in emerging markets was far too rapid and that fundamentals in these countries are more favourable than in the developed world. Therefore, stock markets at current levels—well beyond the rebounds in the developed world—are justified.