The elephant and the dragon
International investors have their eyes on two emerging economic giants
India is facing its worst financial crisis since 1991. After the rupee started to fall sharply against major currencies in May and June, the Indian central bank raised interest rates and imposed emergency capital controls on Aug 14 to prevent capital leaving the country.
Since then, at the time of writing, the Indian rupee had fallen a further 10 percent. Sensex, India's main equity stock exchange index, is down nearly 5 percent year-to-date. What is going on? Does it affect China?
Part of the answer lies on the other side of the world, in the United States. The role of the dollar as the global currency has been much discussed since the 2008 crash, not least by China's central bank governor Zhou Xiaochuan. But with two-thirds of the world's foreign exchange reserves still held in dollars, and most global trade still invoiced and paid for in dollars, the US currency continues to be the world currency, at least for the moment. The decisions regarding the availability and cost of dollars taken by the Federal Reserve at its headquarters in Washington still affect the global economy profoundly, particularly those countries where economies are still developing and where currencies rest on relatively weak foundations.
The current problem dates back to the mid-1990s, when Western multinationals started buying labor-intensive products such as clothing from the developing world, where labor costs were much lower. As measured consumer price inflation fell as a result, the Fed, misunderstanding the fundamental cause of price disinflation, and fearful of deflation, provided itself and the world with an oversupply of dollars.
Later, after the 2008 crash, this oversupply continued, but for a different reason: as an offset to the negative impact of bank and household debt deleveraging. In 2013, as the US economy entered its fourth year of weak economic recovery, the possibility of unwelcome economic side effects started to outweigh the need for artificial economic support. The Fed signaled, at last, that it should bring its monetary support policy to an end. World financial markets, which price the supply of US dollars hourly, immediately started to take the statements of the Fed chairman, Ben Bernanke, into account. The annual return, or yield, demanded by buyers of US Treasury 10-year bonds rose from 1.86 percent at the beginning of January this year to 2.5 percent by the end of June. Since then, the 10-year US bond yield has continued to rise, reaching 2.82 percent in the last days of August. But, against a long-term average annual return of 6.58 percent, the yield is still very low. Two questions in the markets now are: How much higher will US bond yields go? How much tighter will world money get?
Longer-term US bond yields have a large impact on global economic activity. They are used as the starting point in calculating all kinds of asset prices, including housing and stock as well as the future benefits of investments made today. When the cost of money rises, asset prices tend to fall. The value of loan collateral shrinks. As money becomes more expensive, borrowers' costs rise. Individuals, companies and countries that depend on borrowing have to use more of their income to repay their lenders as interest rates rise.
