Resurfacing old anxieties

By Cees Bruggemans, Chief Economist FNB
07 April 2010

Despite rising equity markets last month (our JSE now topping 29300) there apparently will be no respite from global anxiety. How this will influence equity markets, commodity prices and emerging currencies is what exercises the mind.

Having supposedly ‘unsatisfactorily’ sorted out Greece (which over the next 18 months has to raise some €55bn to refinance existing debt, nearly half of it probably through IMF-cum-European lifeboats, yet with Greece already this week balking at the likely terms and wanting to ‘renegotiate’), financial markets are maintaining a ‘high’ Greece spread over German bunds (meaning default risk hasn’t gone away, indeed has drastically risen anew overnight).

Attention will now probably also be increasingly shifting to Portugal, Spain, Ireland, Italy, all of whom could still turn into needy recipients as well. The IMF’s work, like a good mother, apparently is never done, at least in Europe.

These many mainly southern European problem children may yet refocus attention on inner European strains and therefore the viability of the Euro. It may as yet not be out of the woods. Great news for European exporters as Euro strains resurface once again but not its politicians (or foreign exporters into Europe).

But even as Europe is creating another global ripple, global awareness is also very preoccupied with bigger issues governing liquidity, such as the Fed ending special arrangements and bond buying and China tightening more decidedly.

Some people see this as really bad news, reducing global liquidity and stimulus, with downside implications for commodity prices and emerging currencies (and their equities?).

Concern about Fed (and ECB) ending special liquidity arrangements and bond buying may be overdone. Such supports ultimately were financial props and ended up as excess central bank deposits rather than fuelling massive financial and economic credit booms.

The removal of these supports is undertaken as the Fed feels markets have been repaired enough and self-sustaining growth is coming into focus. Time to be less supportive with super liquidity.

Does this necessarily reduce demand? Surely if markets show evidence of being able to carry on independently, the extra support is no longer required to underpin things? Still, liquidity is liquidity and less of it presumably means less price support. It makes people uncertain, at least until they can see how it plays.

China is probably the more interesting question. Like the US, China launched an enormous fiscal stimulus program in response to the financial crisis.

In the US, its growth stimulus should be waning from 2Q2010. It seems China is also pulling in some of such support. In its case, though, the message goes via its local authorities and state banks. Less lending for everything apparently, including land purchases, real estate development and infrastructure.

At the same time, Chinese manufacturing, exports and imports are growing robustly, indicative that China is benefiting hugely from the global recovery but that it is also contributing its bit to its sustainability.

Still, in China’s case it is the excessive credit lending of recent months that is being disciplined from fear of overheating and its inflationary implication.

Thus we hear about bank reserve requirements being tightened, interest rates being raised, banks being ‘told’ to lend less and deposit requirements being forced higher. What waits is a yet bigger issue.

China allowed its currency to appreciate by over 20% against the Dollar in 2007 and 1H2008. But as the global financial crisis deepened it went on hold, happy for its Yuan to shadow the Dollar.

With the global crisis ended, recovery well underway, US insistence growing that China needs to do more to undo the global imbalances (implying a fairer trade deal for the rich West after all its accommodation of China these past three decades) and China itself seeking a greater handle over its internal demand dynamics, a new policy shift could be looming shortly.

Not that China isn’t contributing anything to righting the global imbalances. Its domestic stimulus has been without equal. But the world wants more, especially sustainable moves that are more permanently embedded in trade competition. A revalued Yuan is central to this.

China likes to do things without getting pressurized. Americans are probably not unwilling to threaten trade penalties (import surcharges). A compromise is probably shaping, as much because the global financial crisis has passed and China has its own domestic reasons for wanting to move as Americans insisting on being heard.

Next week Chinese President Hu Jintao will be visiting Washington just ahead of a crucial report to Congress on whether China is a currency manipulator (warranting to be punished). That report is now being delayed. And the Chinese delegation may not arrive empty-handed. More Yuan currency appreciation may be on the cards. But how much?

Financial markets undoubtedly would welcome less confrontation between the US and China and more progress with addressing the world’s imbalances.

But some markets may read falloff in commodity demand and slower industrial growth into all of this.

Some are taking a middle-of-the-road attitude, seeing a marking time in commodity prices for a couple of months, followed by a resumption of robust growth from later this year once stockpiles have thinned somewhat.

Bottomline is that something is cooking. Understanding what it means for financial prices is the difficult part.

Obviously this is a situation in which volatility (price overreaction) is possible. But the Chinese are unlikely to want to slow down their economy too much.

And though US growth may slow somewhat in coming months as inventory repair and fiscal stimulus wane, there is evidence self-sustaining growth is making an appearance.

With global companies strongly insistent on cutting costs (employment) during the crisis and reaping rich productivity gains during its aftermath, corporate earnings repair is well-advanced and still gaining.

This bodes well for global equities, also because big public debts and greater risk discernment about sovereign bonds is pushing down their prices, while cash still wants to leave the sidelines.

This may well favour developed market equities for now, while some of these changes are seen as risk averse for emerging markets. But the overall picture remains pro-growth with short-term interest rates and capital flows (and bond market destinations) favouring still high-yielding emerging markets.

So despite the new bouts of anxieties, the world recovery seems to be supporting good growth gains and financial market support.

South Africa is finding itself a steady beneficiary of global conditions, especially linked to commodities, but the bond (and equity) flows may also still favour us, not only pushing up our asset prices but also the Rand.

The fiscal windfall last week, reducing the estimated budget deficit, has probably improved our market rating (seeing so many other sovereigns under pressure while we apparently improve our numbers effortlessly), but also our small current account deficit may currently need minimal funding.

A current account deficit of 4%-5% of GDP, with unrecorded transactions (probably trade items) amounting to 2%-3% of GDP and Customs Union proceeds owed to neighbouring African countries amounting to another 1%-1.5% of GDP (but transferred in Rand) would suggest we don’t need much foreign capital at present.

So we may well continue to have excess capital inflows coming at us, potentially firming the Rand.

Therefore the Rand still may remain a candidate for testing 7:$ on the downside, even though Fed liquidity and Chinese policy concerns may be feeding some renewed risk averseness globally, potentially keeping the Rand from advancing too far for now, making for 6.80-7.80:$ territory.

Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics