Going down with the renminbi

Emerging markets have faced significant headwinds ever since the "taper tantrum" of mid-2013 when investors began to factor in tightening moves by the US Federal Reserve. Their headache got much worse last summer, when China allowed a mini-devaluation of the renminbi, and 2016 is hardly starting well. The root problem is that most emerging markets are over-geared and need to ease policy if growth is to be kick-started. Unfortunately, easing is largely out of the question when jittery global investors are fretting about a China-induced currency war.

Since 2008, emerging markets have been driven by four key factors; namely, the oil price, China's currency policy and the level of both the yen and euro against the US dollar. The key risk now is a big depreciation of the renminbi, which, unlike my colleagues in Beijing, I consider to be quite likely-they put the chaos of recent days down to bad communication while I think the market is rational to force accelerated depreciation of the renminbi. If the Fed matches market expectations with rate hikes then China's currency can very easily end the year at 7 to the dollar.

My contention is not that Beijing is a currency warrior. Until last August, China was just able to balance the contradictory objectives of cutting interest rates, keeping a stable renminbi and liberalising its capital account. The People's Bank of China managed this breach of the "impossible trinity" through carefully calibrated interventions. That ability to cheat fundamentals, however, was lost in the aftermath of last summer's botched shift to a more flexible currency regime (my point is that it was only a matter of time).

As a result, the market no longer gives Beijing the benefit of the doubt and hence, the basic laws of economics are being reasserted. The central bank can delay the inevitable by selling foreign exchange reserves, but confidence in the unit is waning as shown by its currency pile declining by a record $107.9bn in December versus an expected $23.3bn. This leaves policymakers with some hard choices. My colleagues in Beijing expect Chinese short rates to decline by 100bp this year and the renminbi to only depreciate mildly against the dollar . The only way I see that happening is through a reversal of capital account liberalisation measures (i.e. acceding to the "trinity" dictum that two sides of the triangle can be controlled, but not all three).

A decisive bottoming in Chinese growth may reverse this dynamic, but this seems unlikely given that global demand is slowing and China's private sector is struggling . A backtracking on US rate rises would lower pressure on the renminbi, but such an eventuality would point to more serious problems.

Against this backdrop, few US dollar-based investors will give Emerging Asia a second thought, regardless of whether India's economy improves or Indonesia embraces more accommodative and business-friendly policies . This is because a weakening yuan will apply constant downward pressure to Asian currencies which are costly to hedge. In such a strong dollar environment, foreign debt servicing costs will rise, and any stabilisation of growth will be hard to achieve. Adding insult to injury, it is not even clear that emerging markets (including Asia) offer especially attractive valuations. The overnight suspension of China's equity market circuit-breaker system may ease the immediate panic. But, unfortunately, the negative dynamic between China and its neighbouring markets is not about to quickly reverse.

This is reprinted with permission from Gavekal Research