The People's Bank of China is actively closing possible capital outflow loopholes and this firewall building will allow it to lower interest rates and weaken the yuan, which makes it very likely that we'll see USDCNY passing 7.0 in 2018
The People's Bank of China would like to lower the interest rate to cushion against potential adverse impacts from the escalating trade war and unwind some harsh damages (e.g. bonds defaults) caused by financial deleveraging reforms in 1H18. However, when the 1D interbank pledged repo and overnight SHIBOR fell below 2% - which is the level of the US's Fed funds rate upper bound - it triggered capital outflow concerns from the inverted China-US interest rate spread.
This could be the reason the central bank has guided the interbank interest rates higher than the 2% level after a sharp fall in the first week of August. The central bank also guided the interest rate on 3M government deposit auction stable at 3.7% in August, the same as July after a sharp fall from 4.73% in June.
As we expect another rate hike from the Federal Reserve in September, China's interest rate could be lower than the US again by then. PBoC will have to live with this negative spread because the economy needs lower interest rates to support investments and economic growth in this ongoing trade spat.
Growing trade tensions and increasing emerging market risk have weighed on the commodities complex. The Bloomberg Commodities index has fallen by almost 3% since early August and more than 9% since late May. Oil has been unable to escape this selling pressure, with ICE Brent having fallen close to 10% since late May
It does seem that the synchronised global growth story from earlier this year is losing some momentum. Yes, the US economy is still growing strongly, but with the US Treasury yield curve moving ever closer to inversion, there is concern that this could be a precursor to a slowdown. Meanwhile, trade tensions do not seem as though they will be resolved anytime soon, which will do little to help growth. Already if we look around the globe in recent months, manufacturing PMIs have softened in a number of countries although they still point towards expansion. Adding to this is the potential risk of contagion from the current Turkey crisis. Other emerging markets have already been hit, evident through depreciating currencies, investors demanding higher yields on emerging market debt and a jump in credit default swaps on this debt. However saying all of this, the US Federal Reserve seems unlikely to deviate from its plan for tighter monetary policy, which should remain supportive for the US dollar, whilst growing emerging market risk adds further support to the currency.
So what does this all mean for oil? A number of agencies have highlighted the downside risk to current demand growth forecasts. At the moment the IEA estimates that global oil demand will grow by 1.4MMbbls/d over 2018, compared to growth of 1.52Mmbbls/d in 2017. For 2019, it estimates demand growth will increase slightly to 1.5MMbbls/d. However, the agency has stressed that there is potential downside risk as a result of growing trade tensions and the stronger oil price environment; remember ICE Brent is up almost 58% since the lows of June 2017. Given concerns over emerging markets, this risk is likely even more real now. OPEC also downgraded its demand growth forecasts for 2018 and 2019 in its latest monthly report.
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Bank Indonesia (BI) surprised investors with a 25 basis point policy rate hike. BI has resumed tightening to stabilise the rupiah, which had fallen to its weakest level since October 2015
The Indonesian rupiah (IDR) traded as weak as IDR14680 earlier this week from Friday’s IDR14400. The weakness came amid a worsening in the current account deficit, which was announced last Friday to have widened to -$8 billion or to -3% of GDP in 2Q from -$5.5 billion or -2.2% of GDP in 1Q, and from -$4.8 billion or -1.9% of GDP in 2Q 2017. The currency was also hit by expectations of a steady policy rate decision at today’s meeting as well as the contagion effect of the slide in the Turkish Lira (TRY). Today’s July trade deficit of $2 billion, the highest in five years, indicated that the current account in 3Q could widen further as imports accelerated to satisfy strong domestic demand.
All of this argued for BI’s resumption of its tightening cycle and today's surprise 25 basis point rate hike after a pause in July. This brings BI’s tightening to 125 basis points so far this year. We believe that BI could continue with its tightening cycle until some stability is achieved. Higher interest rates will eventually moderate domestic demand and imports. Import substitution efforts by the government such as using a higher palm oil–diesel blend and redirecting oil exports to the local market, and keeping the fiscal deficit at around -2% of GDP may help moderate growth and stabilise the IDR.
This combination of monetary tightening and government measures could eventually address a couple of the drivers of IDR weakness – the weak external payments condition and strong domestic demand. But these measures will take time to work through the economy, which brings the burden of short-term stabilisation onto the central bank.
As if the global market turmoil isn’t enough, domestic economic developments have been turning sour for the Indian rupee. This provides little hope for a break in the trend of the currency testing new lows against the US dollar. Prepare for more aggressive central bank policy tightening ahead
The Indian rupee (INR) exchange rate per US dollar surged to a record high of 70 when the Turkish financial crisis hit emerging market currencies hard earlier this week. As if the external drags on the INR aren’t enough, the domestic economic data -- a multi-year high trade deficit, elevated inflation, and signs of slowing GDP growth -- haven’t been any friendlier.
With an apparently shallow central bank (RBI) tightening cycle ahead, the current INR depreciation trend looks to be a prolonged one. The next challenge will be a string of state elections in the remainder of this year and general elections in 2019, which should see investors starting to add a political risk premium into local financial assets. As such, we don't rule out an aggressive central bank (RBI) policy tightening at the October meeting. Yet we see no threat to our 71.5 forecast for the USD/INR by end-2018.
Watch ING's Head of FX Strategy, Chris Turner, talk about how emerging market FX, notably the Turkish lira, the Russian rouble and the Chinese renminbi, are coming under increasing pressure amid Donald Trump's 'economic war'China: Cutting our GDP forecast
Aggregate financing shows shadow banking is still shrinking, with sizeable loan write-offs in 1H. Both provide some room for loan growth to support infrastructure investment and SMEs and cushion the economy against damage from a trade war
China's overall economic performance in terms of GDP depends on whether fiscal stimulus and monetary easing are big enough and happening fast enough to offset the negative impact on exports and related manufacturing activity from the ongoing trade war.
As the Chinese government has put substantial stimulus and easing in place, the Chinese economy should not experience a deep contraction. Nonetheless, we are still revising China’s GDP downwards to 6.6% in 2018 from 6.7%. We expect 3Q and 4Q GDP to slow to 6.5% year-on-year and 6.3% YoY respectively from 6.7% in 1H18. This steeper slowdown in 4Q reflects our expectation of 25% tariffs on $200 billion of exported goods to the US becoming effective.
We retain our end-of-year USDCNY forecast of 7.0.
Global emerging market assets have come under pressure as investors gauge the next move in Turkey. Should events lead to more indiscriminate selling of EM assets, those countries that had attracted the lion’s share of recent portfolio flows could be the ones to suffer outflows. The big EM proxies of Poland and Mexico could be at risk in this case.
Global investors have typically been happy to own Emerging Market risk over recent years, although the escalation in trade wars and the dollar rally from early Spring this year has asked some serious questions. That said we are far from seeing a wholesale exodus from emerging markets. Looking at one sub-set of flows – flows in EM local currency debt funds - the retreat has been relatively mild compared to the strong inflows seen through 2016-2017.
An insight into flows into this segment can be gleaned from two popular Exchange Traded Funds (ETFs) that track the JP Morgan EM Local Currency bond index. These ETFs have seen outflows since April this year, but the move looks relatively modest so far. The membership break-down of these ETFs shows Turkey as having one of the smaller EM weightings at 4.0% and 2.4% respectively. This compares to the ‘big beasts’ of the EM debt indices such as Brazil, Mexico, Indonesia, Poland and South Africa, which all tend to have weightings closer to 9-10% in these benchmark indices.
A slide in the Turkish lira, worries about an escalating trade war between China and the US and signs of slowing global growth piled yet more pressure on emerging markets this week. The question now is, can the sell-off be contained or are things about to get a lot worse?