Weekly Economic Briefing

Avoiding policy mistakes

17 January 2017

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Although faced with rising policy uncertainty, emerging market (EM) activity has continued to improve since our last column before Christmas. EM manufacturing PMIs were mixed in December but ticked up in aggregate led by improvements in Russia and China (see Chart 9). Amidst the talk of rising protectionism, EM trade also continued to recover. Aggregate import growth has improved, notably signalling firming domestic demand (see Chart 10), and exports have trended upwards in India, Korea, and Brazil. Likewise, industrial production growth has continued to moderately improve; Russian growth turned positive for the first time in almost a year while Chinese growth has remained stable. This improvement has occurred despite the dollar strengthening and US yields increasing since the US election. Higher commodity prices have boosted the most vulnerable EMs and, more importantly, cyclical tailwinds from stronger American and European demand have supported manufacturing exporters.

Increased dispersion
Improving domestic demand

There is a danger, however, that this improvement will be short-lived; Trump’s appointments, including to the Commerce Department and newly created National Trade Council, signal that his campaign rhetoric may go beyond words. Investors would be wise to take the threat of protectionism seriously. While it is unclear how far Trump’s team will go in changing trade policy, it is also unclear how other countries would react, particularly an emboldened China. Chinese official press have denounced the threats of across-the-board tariff increases and indicated their intention to retaliate. Indeed, they may have taken a pre-emptive step to highlight the leverage they hold over certain US industries by placing punitive tariffs on US animal feed and ethanol imports last week. Trade is not the only area where tensions are running high, recent statements regarding the “One China” policy and South China Sea risk exacerbating an already tense situation. Many deem the US-China relationship as “too big to fail” and that a trade war would, to use the Cold War phrase, result in mutually assured destruction – but the combination of an untested US administration and resurgent Chinese nationalism make cooperation less likely than it has been in decades.

Outside of trade and geopolitics, the Chinese economy is receiving little attention compared to this period a year ago. Indeed, the economy appears stable despite a steady reduction in FX reserves and increased trade uncertainty. Although the mantra of economic, social, and financial stability has taken hold, policymakers are walking a very narrow tightrope. For example, the PBOC wants to lean against credit and asset bubbles with tighter monetary policy but cannot risk increasing stress on highly indebted corporates with higher benchmark rates. Further aggravating the situation, producer price inflation is accelerating well above policymakers’ comfort level. Meanwhile, the authorities are keen to cool the housing market in certain tier 1 and tier 2 cities but cannot risk too sharp a tightening in the housing market given how central the industry is to the overall business cycle. Lastly, policymakers are still stressing the need for more market-oriented reforms but in practice continue to resort to state-led, credit-fuelled investment to drive growth. While we are not predicting a near-term crisis, imbalances are growing and policy missteps are almost guaranteed along an increasingly fraught adjustment path.

Alex Wolf, EM Economist

 
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