A Tale of Two Central Banks

Following the 26th of January, the Federal Reserve announced that it was going to keep its interest rates steady, however, onlookers expect several central bank rate hikes for 2022. Contrastingly, the People’s Bank of China (PBOC) recently cut policy interest rates for the first time since April 2020. A tightening labour market and inflationary pressures in the U.S. has contributed to this expectation of rising central bank interest rates, whereas a dragging property sector and a slowing economy in China has led the PBOC to reduce interest rates to stimulate recovery. This divergence in interest rates has the potential to cause great turbulence in the emerging markets sector.

Interest rate hike expectations in the U.S. has caused concern in the emerging markets sector over rising sovereign debt costs, as many developing nations issue dollar-denominated debt to fund fiscal activities. The raised cost of borrowing would hinder the abilities of governments to influence the level of demand within the economy, as they are met with greater sovereign debt burdens. Similarly, capital outflows may occur as rising interest rates incentivise the flow of ‘hot money’ into U.S. securities that offer a greater return. A worst-case scenario for emerging markets that are highly exposed to the U.S. would invoke domestic investment slowdowns and static levels of demand. However historically, when policy rate changes have been moderated and controlled, emerging markets have not been severely impacted.

According to the latest data compiled by Bloomberg, ‘overseas funds have sold a net 3.1 billion USD worth of shares in Taiwan, South Korea and India’ for the week beginning the 24th January, which followed ‘4.9 billion USD of withdrawals’ the week before. The MSCI Asia Pacific Index, which tracks large and medium-capitalization corporations across 5 developed markets countries and 8 Asian-Pacific developing market countries, lost more than 5% in two weeks according to Bloomberg. Behind the poor performance of the emerging markets index is a reliance on technology shares, whose value is dependent on future cashflows as technology firms project cash flows far into the future.

There also exists systematic geopolitical risk in the form of the Russian-Ukraine tensions, with Russia being a significant exporter of oil, aluminium, copper and wheat. A reduction in the flow of these vital resources could lead to imported inflation in developing nations. Natasha Kaneva, head of commodities strategy at J.P. Morgan Chase & Co., claims that if war were to break out, oil prices could soar to ‘120 USD a barrel’.

There does exist reason to be optimistic in the emerging markets sector. Unlike the Federal Reserve, the PBOC has cut policy interest rates to stimulate demand in the response to the troubled property sector and slowing growth. ‘Because China’s exchange rate policy has become more flexible, maintaining monetary policy independence has become much easier’ claims Yu Yongding, a former PBOC adviser. The liberalization of the Chinese Yuan has meant that monetary policy can become more useful in tackling domestic issues within the economy, as opposed to maintaining an exchange rate policy. For nations that are large exporters of goods and services to China, this should come as a relief. For example, according to the World Bank, South Korean exports accounted for approximately 36.9% of total GDP in 2020, of which 25.9% of total exports were to China, according to The United Nations Commodity Trade Statistics Database (UN Comtrade). Nations that are reliant on Chinese demand for their exports should see this as a relief, with an expectation for export revenues to rise as the Chinese economy recovers.

The divergence between the PBOC and the Federal Reserve invokes a new development in international capital markets as investors and traders will have to decide which currency to anchor themselves to. Resultantly, the PBOC may begin to exert more influence in Asian markets than it had done previously, opening the Asian markets to new dynamics. The sharp fall of the MSCI Asia Pacific index may pre-empt further turbulence dependent on policy rates of the Federal Reserve, however, if rate hikes are controlled then the impacts on the emerging markets may only be benign. The impacts on Asia markets may be less severe due to a greater dependency on the Chinese economy as opposed to in South America where there is a closer alignment to the U.S. economy.

Analyst: Max Cowan

Sector Head: Gregor MacDonald

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