The Divergence Between East and West

The Divergence Between East and West

Andrew Milligan, Asia Scotland Institute Board Member, Independent Economist & Investment Consultant, discusses ‘The Divergence Between East and West’ in a new podcast episode.


Since the start of the year, anyone who has looked at financial markets in the United States of America or Europe must have noticed how government bond yields have jumped much higher. Central banks have signalled more aggressively that they need to take away the proverbial punch bowl from the party. As a consequence, the expectation of higher interest rates has put Western equity markets under pressure. Most emerging market central banks continue to follow the line set by the US Federal Reserve, with aggressive rate hikes seen in Brazil and Russia for example.

However, there are some interesting divergences – two of the largest Asian economies are seeing the situation in a different way.

China is the conspicuous outlier, as it recently did not tighten but actually eased monetary policy slightly, and is expected to do more in the coming year.

Why is it doing this? The answer is to keep the economy stable and offset economic weakness, especially in the construction and property sectors. House prices have recently been falling. China’s property developers started 2022 with poor sales, as many real-estate companies struggled to rekindle interest from home buyers. High profile firms such as Evergrande and Kaisa are just the tip of an iceberg of debt.

It is an unusual development when China is seen as a weak link in the global economy. In the short term, this also reflects a rolling series of lockdowns across the country as President Xi tries to bring the Omnicron variant of Covid 19 under control. There are longer term issues facing his administration as well – demographics are poor, the population of working age peaked a few years ago, whilst there is a secular slowing in productivity, partly due to an inefficient use of capital.

Stability is important for domestic politics. President Xi is obviously keen on gaining a third term of office at the autumn meetings of the CCP, meaning a stable economy would be a helpful backdrop. The recent winter Olympics must have helped his cause!

This is where questions about the US central bank, the Federal Reserve, come in. As the Fed starts hiking rates this year, won’t that hurt the Chinese economy and financial markets? At the margin, yes, the world economy is interconnected. However, we have to remember that global market conditions have limited impact on domestic monetary trends in China. The reason is that China runs a trade and current account surplus, has strict controls on capital flows into and out of the country, and does not have a large amount of external dollar debt.

The Chinese authorities, therefore, have room for manoeuvre. For example, they can control the currency as a quasi-peg against the exchange rates of other major trading partners. The state commercial banking system can be directed about where capital should best flow. We are seeing signals from regulators about the construction of new infrastructure, especially projects to cut carbon emissions. The head of China’s Ministry of Finance recently talked about how his department must raise its political standing and shoulder responsibility for the sustainable and healthy development of the economy, as well as maintaining social stability.

Japan is also on a different path. A few days ago the Bank of Japan made an interesting announcement, namely that it would limit the rise in Japanese government bond yields. The new ceiling will be 0.25%. The current 10 year benchmark yield is a little below that at about 0.2%. In effect the central bank is threatening or promising to buy unlimited amounts of bonds – if required – to cap or limit the rise in yields, that is to hold bond prices up. I say if required because on previous times the bank did not need to do much – the market did not test its mettle. The Bank of Japan can afford to have a very different path to the Federal Reserve as consumer inflation in Japan is still close to zero.

In conclusion, it is quite understandable that businesses here in Scotland, across the UK, the USA and Europe, are all concerned with how high interest rates might go. They need to focus on the state of the labour market, energy prices, company pricing power, and the responses of the MPC, the Fed, the ECB. Two of Asia’s biggest countries are in a very different cycle – China is trying to stabilise its economy in a politically sensitive year, whilst Japan does not suffer from inflation pressures. Risks and opportunities as ever for investors to consider. Much to examine in coming months!

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