World economy needs a stronger Chinese currency, says AXA

Friday 18th December 2009

China's practice of pegging its currency, the yuan, to the US dollar is hampering global economic recovery and is likely to become unsustainable in the year ahead, says the chief economist for AXA Global Investors in New Zealand, Bevan Graham.

In a report on the outlook for 2010, Graham identifies emerging markets as the most potent source of sustainable recovery, but says deep structural changes that are required in the world economy will only occur if indebted countries have weaker currencies, while savers allow theirs to appreciate.

"China is an interesting case in point. When a country has its exchange rate pegged to another, it effectively pegs interest rates as well," says Graham. "If China continues to grow at a strong clip, which we expect it will, and if inflationary pressures remain benign in the United States, which we expect they will, China will need higher interest rates well before the US. All else being equal, the Chinese yuan peg to the US dollar will become increasingly unsustainable in 2010."

Turning to the New Zealand dollar, Graham says the end of expansionary fiscal and monetary policies in the major developed countries may prove the trigger for an over-valued Kiwi dollar to start falling.

Picking that 2010 would be the year of the "great unwinding", following the "great recession" of 2008-09, AXA GI suggests it will be late 2010 before the US Federal Reserve starts to tighten monetary policy, and warns that while slack industrial capacity may help fuel a growth rebound, there is equally a risk that much spare capacity will turn out to be redundant.

Most important will be developed economies' willingness to get fiscal policy back on track, after a frenzy of borrowing and money-printing over the last 18 months.

"For developed economies, on average, to get the debt to GDP ratio down to 60% within the next two decades requires steadily improving the cyclically adjusted primary fiscal balance from a deficit of 3.5% of GDP in 2010 to a surplus of 4.5% in 2020 - an 8% adjustment!" says Graham, citing recent International Monetary Fund analysis.

"Not renewing the fiscal stimulus gets us part way there, but only by about 1.5% or less than a quarter of the 8% shift required. The job ahead is still immense. It is unlikely that economic growth will do the job by itself. That means serious fiscal reform is ahead, and the earlier we start, the less dramatic that reform will be."

Meanwhile, the global financial crisis had created one of the most significant shifts in geo-political power in recent times, with the previously dominant G-7 group of developed nations ceding influence to the G-20, which includes the emerging super-economies of China, India, and Brazil.

With AXA GI judging emerging markets the most attractive venue for equity investment in the year ahead, and emerging economies forecast to account for more than half of the world economy for the first time, in 2014, "emerging markets will be a big part of the solution".

However, their impact on recent orthodoxies regarding monetary policy could be unpredictable when it tests the G-7's influence on the global financial system.

"Belief in the free flow of capital and a belief in floating exchange rates, for example, both of which have been a core premise underpinning the economic development of the developed world, are not shared as widely amongst emerging countries such as China and India," Graham says.

Businesswire.co.nz

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