Can China make EM great again?

Unfortunately for proponents of globalisation today, protectionism is one political stance that these US presidents differ on, but does the withdrawal of the erstwhile bastion of free markets pose a real risk to emerging market economies and the debt they issue?

Other than building an ambitious and costly 2,000 mile wall along the US-Mexico border, the existential risk to EM from the Trump administration is the threat of higher import tariffs in an attempt to boost the US trade position.

During his campaign, Mr Trump suggested tariffs on China and Mexico of 45 per cent and 35 per cent, respectively. While it is unlikely these will occur, his recent trade policy appointments suggest we will see restrictions of some kind in 2017, reversing nearly 70 years of trade liberalisation.

Most hard-currency EM bonds are denominated in US dollars, so the effects of ‘Trumponomics’ could be far-reaching across the EMD spectrum

One protectionist policy already delivered via executive order is the US withdrawal from the Trans-Pacific Partnership (TPP) free-trade agreement.

Its demise represents a major short-term blow to some countries in emerging Asia – most notably Vietnam and Malaysia – but an opportunity for China, which was not part of the TPP negotiations.

The remaining 11 countries may press ahead with the TPP regardless, but this seems unlikely. A regional influence expansion is now on the cards for China via the Regional Comprehensive Economic Partnership (RCEP), which includes the whole of Asean, Japan, India and Korea, but excludes the US.

Declining exports will, therefore, be top of the agenda and, with Mr Trump’s primary focus on US corporate tax cuts and deregulation – more so than his infrastructure spending plan – the competitive edge of EM companies could be eroded.

Perhaps the most serious risk on the horizon for emerging market debt is the combination of US fiscal stimulus and trade protection at this point in the business cycle, which has been extended by the election result.

An injection of fiscal stimulus when the output gap has closed risks a marked increase in domestic price inflation and overheating the US economy in the medium-term, potentially provoking a hawkish reaction from the Federal Reserve.

Combine this with higher import prices from trade tariffs and a border-adjustment tax, rising wages from tighter immigration policies, and a declining trade deficit from increasingly tax-competitive US companies growing their exports – and it is hard to imagine an alternative scenario to an appreciating US dollar pushing the real exchange rate even deeper into over-valued territory.

Most hard-currency EM bonds are denominated in US dollars, so the effects of ‘Trumponomics’ could be far-reaching across the EMD spectrum. However, although central banks in Turkey and Mexico have been forced to hike interest rates as their currencies have come under idiosyncratic pressures since the turn of the year, there is no evidence yet that concerns over rising US interest rates are forcing other central banks to tighten policy.

On the contrary, Brazil and Chile cut their policy rates in January, highlighting divergence across the asset class. This has helped EM yield spreads over US treasuries narrow since Mr Trump’s victory as global growth momentum has accelerated to a six-year high, led by an upswing in advanced economies that has become the driving force behind the recent rally in global risk assets.

A sustained recovery in emerging economies, however, will largely depend on the economic and political trajectory of China this year, where stability is expected to lead to prosperity. Under the leadership of Xi Jinping, China is preparing for another ‘selection year’ – the 19th party congress will be held in autumn – giving its leader an unprecedented opportunity to stack top party and government posts with his allies.

He will want stable and healthy economic data going into this event while balancing a transitioning economy, not an easy task, but one made easier by China’s smoothed ‘alternative facts’ to which markets have become accustomed. Could the early signals from Washington to cease financing the global economy with perpetual trade deficits hinder Mr Xi’s chances, or will Chinese stability and a re-acceleration of global growth in 2017 be what it takes to make EM great again? Only time will tell.

Robert Lee is executive director at Signia Wealth