Just when we were all being lulled into thinking that the global economy was on the mend, trouble has broken out yet again. This time, it’s in emerging markets. Since the beginning of the year the currencies of Turkey, Argentina, Brazil, South Africa, Russia, Hungary, Indonesia, Chile and others have fallen sharply. Several countries have raised interest rates to try and stabilise markets.
This latest financial unrest has undermined global equity markets, and raised concerns about spillovers into the West. Problems in Turkey could affect Greece and Cyprus. Problems in South America could reflect on Spanish banks. Higher interest rates in emerging countries could add to the deflationary pressures already coming from weak global demand, and liquidity tightening in the US and China.
While vigilant about these things, there is a sharp difference of opinion between those who believe the current emerging market currency unrest is momentary and manageable, and those who see it as a darker harbinger of more serious problems in precisely those countries that are supposed to be the beacon of global economic growth in the world. After all, emerging markets now comprise about 40% of global output, and over 50%, depending on choice of measurement. They have recently contributed three quarters of global growth, though that proportion will be markedly lower in 2014-15 as the growth pendulum shifts westwards. So, storm in a teacup, or proper storm?
Caught in US-China crosshairs, but more than that
Emerging markets are caught in the crosshairs of important shifts in interest rate and liquidity trends in both the US and China. In the US, the Federal Reserve announced in December that it would commence ‘tapering’ (or slowly scaling back the purchase of assets under the programme of QE) from January 2014. The concern here is that rising US bond yields will attract back the capital that flowed into emerging markets in the wake of QE. A recent study by the World Bank (Global Economic Prospects, January 2014) estimated that US interest rates, QE and other external factors accounted for 60% of the increase in capital flows to emerging countries between 2009-13, with domestic factors accounting for the remainder. Investors are also anxious that the tapering decision, itself, is a stepping stone eventually to higher policy rates too.
In China, interest rates have been rising too, though further away from the glare of the world’s financial media. As China’s authorities wrestle with the negative consequences of excessive credit creation and rising volumes of bad credit, short-term interest rates, credit risks and corporate bond yields have been moving steadily higher since the middle of 2013. It is widely known that China has been slowing down, but perhaps under-appreciated that the combination of slower growth and rising liquidity risk will have strong ripple effects across the emerging markets universe.
And yet, it would be a gross exaggeration to attribute the current plight of diverse emerging economies to the US Fed and Chinese liquidity alone. Emerging markets have been in a financial funk for a long time, trivialising the flurry of daily commentaries that the Fed especially is to blame. Equity markets have been falling since 2011, the longest losing streak since the Asian crisis in 1994-98, and measures of emerging market currencies against the US dollar are at their lowest for 5 years. Whether emerging markets share problems or have their own script, the issues go a lot deeper than just the last few weeks.
Then and now
The last time emerging countries as a group were in trouble was in the 1990s – the so called Tequila crisis early on, and the Asian crisis and Russian default later. Some people say today’s problems are nowhere near as serious. For example, the external deficits and foreign borrowing ratios of emerging countries today are lower on the whole. According to the IMF, the external balance of emerging and developing nations will halve this year, but still record a surplus of 1% of GDP. This compares with a deficit of around 2% of GDP in 1997-98. But this is also a rather superficial comparison.
The trend in the external balances of leading emerging countries is poor, including for those with surpluses, such as Russia. Trawling through the IMF database of 20 major emerging countries, all but Hungary and Vietnam will have bigger deficits than in 2010-11. Countries with stubborn deficits include Brazil, India, Indonesia, Mexico, Poland, South Africa, Turkey and Ukraine, although some can finance those deficits more readily than others so long as global financial markets choose to discriminate. It’s when they don’t that the rot of contagion sets in.
Foreign debt ratios may be lower, but domestic debt is substantially higher, for example, in China, Brazil and Turkey. In developing Asia, domestic non-financial debt as a share of GDP has surged to exceed that of the US. This follows many years in which credit creation has been allowed to run amok, resulting in high inflation in some countries. A lot of countries switched from borrowing in US dollars to developing larger local currency debt markets, such as Turkey and Mexico. But foreigners have been highly active and this just means that financial risk goes up if and when foreigners take their money out. In fact, in a just published report, the Bank for International Settlements, or the central bank of global central banks, reckons that emerging markets may be more vulnerable to financial and economic dislocation now than they were in the 1990s. (The global long-term interest rate, financial risks and policy choices in emerging economies, February 2014).
Finance is important, as bankers, asset managers and finance commentators insist, but you have to take a broader view too. Exchange rates and monetary systems aren’t only exchanges where money is made and lost. They reflect economic and political conditions, stresses and challenges. My contention is that the current wobbles in emerging currency markets reflect a little understood hiatus in economic growth and development.
For 15-20 years, economic performance has been persistent and widespread – spectacular in the case of China – under the most benign global conditions seen in a generation. But those conditions ended with the financial crisis in 2008. For emerging countries, serial growth disappointments are now common. The export-dependence of their growth models is now double-edged because selling goods to Western consumers is tougher. The reliance on credit creation as a substitute for economic reform is now resulting in high inflation or financial stress. Many of the things that propelled economic catching-up over the last decades are unrepeatable: you can only join the World Trade Organisation once, move rural workers to high productivity urban manufacturing once, put most of your children through secondary school once, build essential economic infrastructure once, and so on.
Many emerging countries have indeed escaped poverty and become middle income countries, with income per head of between $2,000-12,000. But it’s what comes after that matters now, and you can’t extrapolate the past. Development economists have documented that countries cannot sustain double digit growth for more than a decade, always slow down sharply if they have relied too much on credit creation, and need to reboot their growth models when they reach the the upper echelons of the middle income range. And that’s where many major emerging markets are now. Some, particularly those in latin America, but also Malaysia have been here for a long time. Breaking out of this middle income trap, which has proven elusive for the bulk of middle income nations, requires something special: robust, inclusive economic, political and legal institutions, including the rule of law.
The real emerging markets ‘crisis’ then is about weakening growth, which is even more important in young, populous countries with a proverbial ‘rising middle class’ than in our beleaguered Western world. The consequences of this hiatus are on show in different places at different times but have been manifesting themselves from Bangkok’s Khao San Road to Istanbul’s Gezi Park to Brazil’s favelas and urban shopping centres. It is small wonder that political tensions are rising in emerging countries.
So next time someone says emerging market currencies are a storm in a tea cup, you can remind them of two things. First, you can point out that slower growth, flawed development models, excessive reliance on credit and foreign capital inflows, and weak institutions constitute a rather different cocktail. Secondly, you can emphasise that raising interest rates to defend your currency doesn’t always work. It might just exacerbate the underlying problem of weak growth, low returns to investment, and political tension, and so spur another bout of capital flight, and so on.
At some point, a buying opportunity for the brave and fleet of foot in emerging markets is as certain as night follows day. But the emerging market growth crisis is still in Act 1 of a rather long play.