By John Richardson
IF you thought the 2013 Taper Tantrum was bad enough, I am afraid you have seen nothing yet. When the Fed finally does raise interest rates, either this year or next year, these are just six results:
- Whilst the perception out there is that emerging market sovereign debt is not as bad as it was immediately before the 1997-1998 Asian Financial Crisis, just about everyone confirms that there has been a sharp rise in private and corporate dollar-denominated debt. So the stronger dollar that would result from a US interest rate will trigger debt defaults.
- A US interest rate rise will also cut off short term capital flows that finance current account deficits in commodity-exporting countries such as Brazil, Russia and South Africa.
- And, of course, a stronger dollar – and all the global growth implications resulting from a US rate hike – will result in price falls in oil and other commodities, so badly damaging the economies of the commodity exporters. Oil prices will, for example, continue head back down towards their historic average price of $30 a barrel.
- You might want to argue that weaker emerging market currencies would, however, boost export competitiveness. Instead, though, I see this as a zero sum game. Currencies will fall and fall, leaving on a net basis no one country better than any other country, with one crucial and outstanding exception: China. If China joins in this currency war through a further substantial depreciation of the yuan, it has the vast overcapacities and supply-chain advantages to win any export-price war.
- Even assuming that the yuan is not dragged into this currency war, all the above are still sufficient to add to the global deflation crisis that I have been warning about since late last year. We are already in a serious global deflationary crisis, even without a Fed rate rise, which is why talk about inflation being a problem only a short distance down the road is I think wrong. Globally, we have too much capacity in oil, gas, other commodities and manufactured goods chasing too little demand.
- There has been a big increase in foreign funding to Chinese banks over the last six years. And so when Fed rates increase, this will close the door to this route to capital for Chinese investors. So China would have to start regularly liquidating its $1.27 trillion of US Treasuries. This will cause US borrowing costs to rise even further, thus adding to US dollar strength and problems with emerging market currencies and debt repayments etc. that I ave outlined above.
These Six Big Consequences In More Depth
The other big problem is that these six outcomes will occur as China’s economy continues to slow down. This is a huge deal for emerging markets, given their dependence on China as a source of growth.
This is complex stuff and so next week on Monday, Tuesday, Wednesday and Thursday I will run a special series of blog post that will go into some of these six immediate consequences of a Fed rate hike in a lot more depth.
This will lead us up to 17 September (18 September my time), when we should know whether or not the Fed will hike rates this September, after its latest Federal Open Market Committee Meeting.
And if the Fed says no on this occasion, you can print and keep or electronically store the posts for whenever the hike does happen – whether it’s in October, December or next year. This will hopefully help you with what is going to be an ever-complicated short-term planning process for the chemicals industry.
On Monday, my theme will be the potential for a much more substantial depreciation of the yuan, and what this would mean for the global chemicals industry.
What More Realistic Emerging Market Growth Will Look Like
But as this we are approaching the Western weekend, when some of us will have a bit more time to sit back and think (apologies to my friends in the Middle East if this post has arrived too late), I thought it was worth focusing in the rest of this post on longer-term issues.
What the Fed interest rate rise should make everyone realise – even if it is then followed-up by another round of quantitative easing which again won’t work – is this: You have to stop believing all the myths about what drives sustainable emerging markets growth. This applies to all the countries that fall in the emerging markets category, not just China.
One myth common to the entire region is that it is rapidly becoming middle class by Western standards. This has always been nonsense, with the nonsense gathering damaging credence because of all the short-term capital inflows detailed above. These inflows have led to frothy real estate markets and increases in high-end consumer spending etc., and so the illusion of widespread levels of Western middle class wealth.
Real estate and high-end consumer spending has already collapsed in China because of the end of its stimulus programme. The same will happen in other developing countries when the Fed starts to tighten.
The reality has instead long been that most of the people in Africa, Asia and Latin America are very poor by Western standards. This was underlined by a recent Pew Research study, which found that just 1% of high-income populations live in Africa, 4 % in South America and 8% in Asia and the South Pacific.
So what these people have always needed is very cheap but good quality, long lasting consumer goods – for example, a $50 refrigerator or a Chinese smartphone that costs much less than an Apple or a Samsung phone.
Cost is clearly a major problem for chemicals companies supplying the raw materials for these finished goods, yes, but volume isn’t. Get the costs right and the volumes will be huge over the next ten years and more as the emerging world gets very gradually richer.
The other area of focus for long-term thinkers in chemicals companies is how they themselves – along with NGOs and local and national governments – can help satisfy basic needs.
These basic needs include sufficient access to modern sanitation, safe drinking water and basic education and healthcare. You cannot rise out of poverty if you are took sick to go to school because of water-born dysentery, assuming that you have a decent school to go to in the first place.
And all these solutions have to be achieved with ever-lower carbon footprints.
In May, Anna Stupnytska, an economist at Fidelity Worldwide Investment, told the UK’s Daily Telegraph newspaper: “Fed rate rises could end up being just another reason for investors to take a more nuanced looked at emerging economies.”
Anna was right, except that I would replace the word nuanced with realistic.