Emerging markets must correct imbalances

Dari Financial Times.

Insight: Emerging markets must correct imbalances

By Francisco Blanch

Published: January 9 2008 16:24 | Last updated: January 9 2008 16:24

Recent US interest rate cuts have helped create a liquidity boom in emerging markets (EM), fuelling demand for raw materials and boosting stock markets. In turn, robust demand and a global oil supply contraction in the third quarter of 2007 recently pushed crude oil briefly above $100 a barrel. Meanwhile, the US dollar is close to record lows, both against the euro and on a broad basis. More interestingly, the long-term correlation between oil and the dollar has moved from a historical average of -1 per cent to -80 per cent of late.How are the spike in oil prices and the slide in the dollar related?Ultimately, they are linked to one common theme: the ambition of EM countries to support exceptional domestic economic growth by using non-market based mechanisms. Since China became a WTO member at the start of the decade, first a pegged and then a semi-pegged currency regime has kept Chinese labour extremely competitive, fuelling export-oriented domestic growth for years. A similar development has taken place in other EM countries.

The resulting massive current account surpluses and gigantic build-up in foreign exchange reserves has boosted domestic liquidity, ultimately supporting the demand for supply-constrained raw materials.

As commodity prices rose, China, India, Argentina, Russia, Iran, and others rushed to cap retail energy prices in order to protect their economies. In our view, this “twin peg” of forex and domestic fuel prices has been the main source of oil demand growth and price appreciation in the past four years.

More recently, a credit crunch combined with rapidly falling house prices in the US accelerated the imbalances and pushed the Federal Reserve to lower interest rates aggressively, in spite of the potential inflationary risks.

But unsustainable twin deficits in government and external balances and an overleveraged consumer had already led to a deterioration in the economic position of the US. As a result, the dollar depreciated sharply, and further exacerbated this “twin peg” imbalance. As neither EM exchange rates nor domestic commodity prices could adjust to slow EM oil demand, world commodity prices measured in dollars had to trend sharply higher in an effort to slow down oil demand in notoriously price-inelastic OECD economies.

In effect, world commodity prices (mainly oil) have been the main mechanism of adjustment in the face of pegged currency and domestic commodity price regimes. This system of artificially capping both exchange rates and commodity prices cannot go on forever, and EM inflation is rising rapidly.

There are not enough raw materials to fuel regular 12 per cent yearly economic growth in China or other EMs. A soft landing of oil and the world economy in 2008 is feasible, but emerging markets may have to react soon to achieve it. If they act swiftly to revalue their currencies and hike domestic fuel prices, world energy demand growth might slow and some of the problems might be reversed.

This adjustment has started. In spite of their recent vow to freeze government regulated prices to fend off rising inflation, China lifted domestic petroleum product prices 10 per cent in November. But domestic fuel prices are still well below global prices, suggesting there is significant pent-up inflation in the system.

Since regulated domestic oil prices have to move up 30 to 40 per cent to catch up with world oil prices, the Chinese and various EM governments face two stark choices to curb energy demand: either cool the economy or increase domestic fuel prices. The first choice will likely come with a revaluing of the yuan, dramatically eroding export competitiveness.

The second would result in substantially higher inflation, forcing a sharp interest rate rise. In our view, a combination of the two might prove to be the less harmful solution, resulting in a soft landing.

Yet the world economy might face a hard landing if China and other EM countries fail to re-adjust their twin peg, and the imbalances continue to grow. If, in addition, commodity markets suffer an external shock coming from weather or geopolitics, oil prices could spike beyond $150 a barrel.

The writer is head of global commodity research at Merrill Lynch

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