CITI’S TAKE
Our central-bank calls have become more hawkish as inflation is marked up more than growth (in aggregate). Concerns over global imbalances are centered on trade protectionism backlash and financial-stability risks. The Mideast crisis is unlikely to meaningfully alter these risks. Trade backlash from what is now being called “China 2.0 Shock” will likely persist – all eyes on EU-China trade tensions. Financial stability risks are also rising, with fears that intensification of any US crisis could worsen if the US decided to become more coercive in its response. We discuss likely EM policy responses to mitigate these risks.
EM inflation is being marked up more than growth being marked down, leading to more hawkish EM CB pivots: We delay/pare back easing calls in Nigeria, Brazil and Turkey, add hikes in Korea and Taiwan alongside their growth upgrades, but add hikes in South Africa, Pakistan, Philippines despite economic headwinds. Chile and Israel are two notable EM exceptions to the hawkish pivot.
Concerns over global imbalances appear to be rising due to trade protectionism backlash and financial stability risks. While global imbalances are still about 21% below their 2006 peak, the interplay of policy volatility from the largest net debtor country (US), concentration (and leveraged nature) of some creditor flows, and weakened multilateralism, potentially raises risk of disorderly adjustments.
Middle East crisis is unlikely to meaningfully alter risks associated with global imbalances, especially given the offsetting effect of AI capex boom. Instead, it may push net energy importing EM to undertake tighter macro adjustments.
Trade backlash from China’s next phase of economic & tech development, known as “China 2.0 Shock”, is intensifying: We see growing trade backlash against China not only from the EU but also from the Global South. Watch for prospects of EU policy response via Industrial Accelerator Act, proposed update to the EU cybersecurity law and potential new safeguards against Chinese import surges, though EU’s strategic vulnerabilities and China’s retaliatory tools, including recent expansion of its legal arsenal (Decrees 834 & 835) pose challenges.
Financial stability risks are rising amid the greater role of non-official asset accumulation, particularly NBFIs in financially intermediating global/EM savings, which mean elevated leverage, liquidity mismatch and high interconnectedness. A US-originated crisis could either come in more conventional forms (i.e. US remains a safe haven) or from a “sudden stop” wherein US Treasury itself sees an erosion of safe-haven status from fiscal/inflation credibility risks. Liquidity shock of a US crisis could be aggravated if the US responds in a less co-operative way, e.g. more restricted swap line access and/or capital controls to non-resident holdings of USTs.
EM policy responses to US crisis scenarios: 1) Boost reserve buffers, or extend IMF engagement (for EM frontier); 2) diversify US Treasury exposure; hedging USD exposure less clear; 3) ensure strong capital buffers; and 4) which China is pursuing, to promote oneself as an alternative safer asset not only to receive diversification flows, but to gain geopolitical clout by being an alternative global liquidity provider.
