Fed tightening:
Emerging markets feel the chill, but not China
Text / Guan Tao
Published in the 1032nd issue of "China News Weekly" on January 21, 2022
For most of the time since the pandemic, the Fed has used "transient" inflation to fend off calls for austerity.
Until the inflation data broke out, the labor market was extremely tight and inflation expectations were rising, the Fed had to abandon the "temporary" inflation language and issued a "hawkish" declaration after the first interest rate meeting in 2022: every interest rate meeting is not ruled out The possibility of raising interest rates at the meeting requires a large-scale reduction of the balance sheet.
Even if everyone knows that the currency flood will recede sooner or later, emerging market countries will always suffer more "hurt".
At the beginning of the new year, the International Monetary Fund (IMF) once again reminded emerging markets and developing countries to prepare for Fed tightening.
However, China is a "special" emerging economy, capable of taking into account both Fed tightening and steady domestic growth.
The Fed is already behind in raising rates
The Fed's interest rate decision function follows Taylor's rule, and its main goals are price stability and employment maximization.
In the early days of the COVID-19 outbreak, the Federal Reserve quickly cut interest rates to zero, while implementing unlimited quantitative easing.
In order to further strengthen the easing expectations, the Fed adopted a new monetary policy framework of "average inflation target", that is, allowing inflation to exceed the 2% inflation target for a period of time, which directly led to the timing of interest rate hikes being later than the traditional Taylor rule. .
The result of a currency flood is either rapid inflation, high asset prices, or both.
In 2020, it is mainly manifested by the surge in U.S. stocks and soaring housing prices, and since April last year, it has been manifested by the continuous “outbreak” of inflation.
The newly announced US CPI and PCE inflation growth both hit new highs in nearly 40 years, completely frightening the US Congress and the White House.
The tight U.S. labor market has kept the Fed from sitting still.
If the ultra-low interest rate environment is the breeding ground for inflation, then wage growth is the nutrient for inflation growth.
Moreover, wage growth would make inflation more resilient.
Non-agricultural data showed that in January this year, the hourly wages of U.S. workers increased by 5.7% year-on-year, the highest in nearly 20 years.
In particular, historically high turnover rates and labor shortages give labor negotiating an edge.
Rapidly rising inflation would also be an excellent reason for workers to demand higher wages, creating a “wage-price” spiral.
Although there is still a distance from the hyperinflation of the 1970s, residents' inflation expectations have been significantly higher than pre-pandemic levels, with both 1-year and 5-year inflation expectations significantly higher than the Fed's target of 2%.
The Fed will never let inflation expectations untangle, and there will be self-fulfilling inflation in expectations and prices.
The Fed's economic outlook is entirely pointed towards a tightening path.
The Federal Reserve’s economic outlook forecast released in December last year showed that the U.S. unemployment rate (3.5%) in the next three years will be lower than the U.S. potential unemployment rate estimated by the Congressional Budget Office, achieving the so-called maximum employment; GDP growth in 2022 will still be higher than the potential Growth; PCE inflation may not approach the Fed's target until 2024.
This is indeed the case. Although the non-agricultural unemployment rate rose slightly to 4.0% in January this year, it was still lower than the potential unemployment rate, and the labor force participation rate rose significantly to 62.2%, indicating that the withdrawal of stimulus policies and the tight labor market are attracting American workers. Returning to the job market, the job market is at risk of overheating.
Therefore, controlling inflation has become a top priority for the Fed.
The market expects that the Fed will raise interest rates more than 4 times this year, and the balance sheet will begin to shrink in the third quarter as soon as possible.
After the US CPI data for January was released on February 10, 2022 Eastern Time, the market believes that the probability of raising interest rates by 50 basis points in March exceeds 75%.
Emerging economies have to guard against Fed tightening
The vulnerability of emerging markets and developing countries in terms of debt, exchange rate exposure and external sector makes them very fearful of Fed tightening.
However, not all countries will be affected in the same way.
Moreover, some emerging economies have raised interest rates ahead of schedule in response to the upcoming Fed rate hike.
According to statistics from the Central Bank News website, excluding Zimbabwe, 33 developing countries have raised interest rates by 84.55 percentage points since the beginning of last year.
However, due to the poor historical performance, the IMF still warns emerging economies that they need to make a choice. Raising interest rates may inhibit economic recovery and increase debt burdens. If interest rates are not raised, they will have to suffer "abnormal" capital outflows.
Since the outbreak of the new crown epidemic, the macro leverage ratio of emerging economies has increased faster than that of developed countries.
In the early stage of the epidemic, emerging economies lacked sufficient financial resources to support the normal operation of the economy; after the vaccine was available, emerging economies were unable to establish immune barriers on their own to promote the normalization of economic activities, which also led to the economic recovery of emerging economies later than that of developed countries.
According to BIS statistics, as of the second quarter of 2021, the leverage ratio of the non-financial sector in emerging economies increased by 30.2 percentage points from the end of 2019 to 231.9%, higher than the 26.5 percentage points in developed countries.
In addition, the resilience of the external sectors of emerging economies has increased.
Material shortages and non-production in developed countries, coupled with skyrocketing commodity prices, have directly made the export trade of emerging economies a lot of money.
According to data from the United Nations Conference on Trade and Development (UNCTAD) and the World Bank, the current account surplus of emerging economies in 2020 will increase by 0.7 percentage points to 1.3% of GDP compared with 2019.
Brazil has been in a current account deficit, coupled with high domestic inflation, raising interest rates ahead of schedule is justifiable.
In addition, the consumption of foreign exchange reserves may also be one of the reasons why individual countries raise interest rates ahead of schedule.
According to IMF data, the foreign exchange reserves of Brazil, South Africa and Turkey in 2020 all declined to varying degrees compared with 2019, while Russia and Thailand increased.
The broad dollar trend will determine whether there will be a large amount of capital flight from emerging economies this time.
The narrowly defined U.S. dollar index contains only 6 major currencies.
At present, with the exception of Japan, almost all developed countries have a one-way tightening of commodity policies. Even the European Central Bank has recently changed its tune that it needs to be alert to high inflation. The only difference is who will be more "hawkish".
As such, this would be particularly detrimental to the exchange rates of emerging economies' currencies, which, after all, need weaker currencies to complement stronger developed ones.
The IMF's research found that the broad US dollar index has a strong negative correlation (-0.67) with capital flows in emerging economies, and the strengthening of the US dollar in 2021 has begun to restrain capital inflows into emerging economies.
In addition, the 10-year US Treasury bond still has room to rise, coupled with the potential financial turmoil caused by austerity, the life of emerging economies is not easy.
Three major factors support China's macro policy
China has advantages in the external sector, exchange rate and policy space to deal with Fed tightening.
First, China's external sector is resilient.
Thanks to the effective prevention and control of the epidemic in the early stage, the smooth resumption of work and production, and a strong supply chain and industrial chain, China's exports have repeatedly achieved good results. The current account surplus in the third quarter of 2021 still accounted for 1.6% of GDP, 0.5 percentage points higher than the same period in 2019. .
Considering the high growth of nominal GDP in 2021, the net export alone will be more prominent. In 2021, China's trade surplus will be 676.4 billion US dollars, a record high, resulting in a situation of oversupply of US dollars in China.
In addition, the mismatch of private capital in China has improved significantly compared with that before the "8.11" exchange rate reform in 2015, and the proportion of net external debt to GDP has dropped to less than 10%.
Second, the RMB exchange rate is flexible.
Since the "8.11" exchange rate reform in 2015, the two-way fluctuation of the RMB exchange rate has gradually become the norm, and the degree of marketization has increased significantly.
Since the epidemic, the overall RMB exchange rate has shown a strong trend, and many foreign exchange policy adjustments are all corrections to the overshoot of the appreciation.
Even at the end of last year and the beginning of this year, the People's Bank of China cut RRR and interest rates together, and the interest rate gap between China and the United States has further narrowed, the RMB exchange rate is still strong.
Although it is not ruled out that the global financial turmoil may trigger foreign capital to cover the United States, the power of foreign capital in China's financial market is relatively limited and is still in the allocation stage.
The medium and long-term trend of the exchange rate still depends on the fundamental changes of China's economy.
Finally, China's macro policy space is sufficient.
This time, China did not introduce a monetary easing policy similar to the flood of developed countries in response to the epidemic.
Due to the rapid recovery of the domestic economy, China's macro policy normalization is also ahead of developed countries.
In particular, unlike overseas countries, China's current consumer inflation is still relatively weak, and domestic consumption is recovering slowly, which does not constitute a condition for monetary policy tightening.
On the other hand, stabilizing leverage last year turned into de-leveraging, and a large amount of fiscal funds lacked a place to go, which also reserved fiscal space for steady growth this year.
To sum up, as Gita Gopinath, First Deputy Managing Director and former Chief Economist of the IMF, pointed out in the release of the latest World Economic Outlook, once global financial conditions generally tighten, all countries will be affected, including China inside.
However, China's economy is resilient both internally and externally, with a small degree of currency mismatch, a large room for macroeconomic policies, and a strong overall anti-risk capability.
The main contradiction in China this year is to coordinate epidemic prevention and control and economic and social development under the premise of normalizing epidemic prevention and control. Through the coordination and linkage of fiscal and monetary policies, cross-cyclical and counter-cyclical adjustments are organically combined, so that domestic demand rises and external demand falls, and guide Economic growth stabilized.
People from all walks of life have long expected China to adopt a neutral and slightly loose macro policy. The next step is to test the results.
Of course, it is still necessary to always pay attention to the spillover effect of the Fed's tightening, adhere to the two-way fluctuation of the RMB exchange rate, monitor capital flows well, and properly guide market expectations.
(The author is the global chief economist of BOC Securities)
"China News Weekly" Issue 6, 2022
Statement: The publication of "China News Weekly" manuscripts is authorized in writing