Emerging Markets Weekly

In recent weeks, I have been reading a great deal about the China stimulus package and the potential for overcapacity due to the overwhelming focus on investment and infrastructure spending. The sentiment is clearly turning, call it phase three in the global slowdown and China recovery story.

The first phase was dominated by selling and fears that China was headed for a massive recession. The second phase was the turnaround story for both the economy and the stock market as the doubters eventually came onside to the recovery view. And finally, phase three is a transition to renewed fears, this time about the sustainability and quality of the growth.

These are good questions to ask, and there is undoubtedly validity to the concerns that China is spending its way out recession through brute force. There will be overcapacity and low returns to many projects.

On the other hand, retail sales figures are encouraging. The data shows that retail sales volumes have jumped considerably over the past year thanks to the stimulus package. It is difficult to tell how reliable the data because it is purported to include some government and corporate spending.

Nevertheless domestic consumption growth is a response to government stimulus measures. Auto sales for example are very strong—with China recently leapfrogging to the number one spot in global auto sales.



Investors need not fear a collapse in spending in the near term because the stimulus extends to 2010. Bank lending is being reined in and that is evidenced by a slowdown in lending and the money supply between June and July but the authorities are not about to slam on the breaks too hard.

It will take policy makers years to rebalance China’s economy from saving toward consumption, and the path forward will not be straight. But over the next fifteen years, hundred of millions of people will urbanize, their incomes will rise and so too will consumption as the middle class grows.

If we have to choose between the U.S. economy that can barely eke out growth with trillions of dollars of stimulus or China’s that is responding to its stimulus package and over the long term has so much greater potential for growth, I take China, hands down.

Emerging Markets Weekly

Up until last fall, most currencies of emerging market countries appreciated strongly versus the US dollar and to a lesser extent against the Canadian currency. This extra kicker to equity returns, reversed at the time that equity markets fell in the emerging countries last year with the notable exception of China, where the RMB largely stopped appreciating.

The slowing of foreign direct investment and reversal of portfolio flows led to this currency weakness despite large U.S. dollar foreign exchange reserves in the BRIC countries, China once again being the exception to this rule. The large foreign currency buffers did allow central banks the ability to manage foreign currency depreciation when the crisis was at its peak.

In China's case, authorities have resisted the natural currency appreciation that would have occurred due to the country's very sizeable trade surplus that exceeded 10% of GDP for several years. Moreover, capital flows did not turn sufficiently negative to significantly reduce the $2-trillion plus worth of dollar reserves at the central bank's disposal. Authorities also made it clear that they would not seek a policy of competitive devaluation with the RMB to boost trade but opted instead for fiscal and monetary stimulus measures.

The strengthening positions for the emerging markets this year means that currency appreciation is back on the table-- and has been happening. Over the long term, we should expect to see a rise in exchange rates for the BRIC countries due to higher rates of productivity in their tradable goods sectors. Therefore, India and China would benefit most from this phenomenon. The Balassa-Samuelson effect is the formal name for this theory that seeks to explain why price levels tend to be higher in higher income countries. The answer alluded to here is that higher productivity in tradable goods is the reason and explains why countries such as China and India with higher rates of productivity in the tradable goods sectors should experience appreciating exchange rates over the long term.

It is this phenomenon why investors will get a foreign currency headwind from investing in emerging markets.