As things stand today, the world finds itself in the midst of the US-China wedge. No one wants a global currency debacle but this remains a possibility, given the tensions that are building up across the two main economic giants with developing countries squeezed in the middle
America is still the world’s largest economy. China has climbed up to second rank, after surpassing Europe and Japan. Some may ask why should a small economy like Mauritius bother with what is going on at the level of these global economic giants. We should, because the condition those two economies are finding themselves in may have important repercussions for us if we are caught napping.
China’s current predicament
The improvement to global second rank in the case of China was the result of sustained economic growth over several decades, on the back of its export drive in particular. But the Chinese economy has slowed down of late. Its annual growth rate is no longer in double digits as it used to be many years during the first decade of the 21st Century.
It is struggling to hit an overall economic growth rate of 7% for 2015. Exports have fallen sharply; in July 2015, Chinese exports dropped by 8% while its factory gate prices also fell by 5.4%. Factory gate prices reflect adjustment to prices in situations of oversupply; they have been falling continuously for 41 straight months.
The situation shows that investment in production capacity is mismatched to the state of global demand for China’s products despite the cheaper output prices. Given this state of affairs, the Chinese central bank devalued the Yuan in a surprise move on 11th August by 1.9%. This was followed by another devaluation the next day by 1.6%, altogether by 3.5% in the space of two days.
The surprise was due to the fact that for a long time now China has refused to adjust its exchange rate in the face of serial accusations from the West that it wasn’t allowing its currency to appreciate to reflect its sustained external trade surpluses and that it was therefore using the exchange rate artificially to keep exporting to the rest of the world. In fact, China had been pulling its currency along to match the recent months’ strengthening of the US dollar… until the 11th August.
This situation changed on 11th August. It sparked fears on the markets that China would be deliberately allowing its currency to fall to benefit its exporters. There was a chain reaction: currencies of several countries from Malaysia, Indonesia, New Zealand, Australia to Singapore plummeted on fears that there could be sustained depreciation of the Yuan to boost up Chinese exports to the detriment of other countries’ exports. China has of course reassured markets that such was not the case.
Notwithstanding, the lower Chinese growth rate has been affecting other parts of the international market. Since China is perceived as “the factory of the world”, its falling growth rate has raised doubts about the sustainability of global demand for commodities. Commodity prices have accordingly been falling: by 40% since their peak levels in 2011. Countries which supply commodities, from Peru to South Africa, are affected by this downward pull of commodity prices. We know that South Africa, for instance, is cruising at an annual growth rate of only 2% and that the social situation over there has been deteriorating.
The answer to all this would have been a pickup of global demand. It’s not easy to contemplate this pickup with Europe – our principal export market — growing at barely 0.3% the last quarter.
What will America do?
Trouble appears to be also coming from another front: America, the world’s largest economy. US economic growth rate of 2.3% is not that bad, given the times we are living in. It has been increasing its employment intakes regularly. In July, an additional 215,000 were absorbed in employment. The US unemployment rate is barely 5%, in sharp contrast to the 11.1% average for the Euro area, where individual countries are grappling with unemployment rates as high as 22.5% (Spain) and 25.0% (Greece).
The US Federal Reserve Bank (Fed) has for long been contemplating hiking up the key US dollar fed funds rate, to reverse its falling trend over a long stretch of time taking it at present to as low a level as 0 to 0.25%. It barely has cushion at such a low level to effectively employ the interest rate lever up to influence policy. Should that happen, funds from outside the US would flow back into the US dollar. In practice, it means there will be massive capital outflows from especially emerging countries into the US dollar, a reversal of the past trend when US dollars went out to seek investment berths in other developing countries. If so, the US dollar will become even stronger, hitting adversely the US export drive.
Seeing the danger, the Fed’s Vice Chairman, Stanley Fischer, announced on 10th August that the anticipated rate hike will not be for coming September. This had the effect to calm down international currency markets and to prevent the US dollar from going up to yet another peak and precipitating an international chaos.
Whatever the decision, capital flowing out of developing countries back into US dollars at some stage would impact their growth potential. Secondary effects of a US interest rate hike will be to increase the debt servicing burden of all those in developing countries who have borrowed US dollars due to the low interest rate attached to it. Central banks in these countries may then let their exchange rates go down and raise local interest rates to defend their currencies. The effect will be to stifle domestic growth prospects, given that global demand has weakened, as illustrated by the China case. Inflation and social instability will creep in, by the same token.
As things stand today, the world finds itself in the midst of the US-China wedge. No one wants a global currency debacle but this remains a possibility, given the tensions that are building up across the two main economic giants with developing countries squeezed in the middle.
The situation doesn’t look too rosy for a country like Mauritius. We’ve seen ourselves overtaken by other cheaper producers in global export markets in the course of time. That’s why we haven’t kept sustaining the expansion of our commodities export sector as much as we would have wished for. Competitors have captured markets we would have supplied to. The end of the Multi Fibre Agreement meant that we were hurled directly into competition with those low-cost-high-productivity producers. We had to develop other advantages (increasing production efficiency, maintaining customer loyalty, price competitiveness, quality of production, extending the production range). We have done so but to a limited extent.
Nevertheless, we still have managed to keep our export sector growing, albeit at a fairly slow pace. Being an essentially export-oriented economy (our internal market is too small and we did not act to modernize ourselves enough to raise its scope in the manner of a Singapore or a Dubai), we have to rely on external markets picking up as much as possible of what we produce.
If it comes to a currency war at the level of the economic giants, we’ll have to keep sufficient spare capacity to react, in terms of the exchange rate. That is why it was not judicious to spend that capacity when problems like those we are currently seeing on the horizon had not materialized.
If capital were to flow out from developing countries en masse towards US dollar assets, we should be able to add some positive notes to the local investment environment. We may have hurt the investor sentiment of late but it’s never too late to do a good thing by reversing all this, given the risk faced in the current international situation by so many countries all at once.
The main comfort we have is the type of moderated reaction experienced central bankers of major economies will post in the situation, along the lines of what Stan Fischer did on 10th August. If the markets react with calm, unproductive confrontation will be avoided. Meantime, a country like Mauritius will get the opportunity to beef up its economic springs strong enough to resist the gales of upcoming international uncertainties.
- Published in print edition on 21 August 2015