Déjà vu in emerging markets
For decades a number of emerging markets have been evolving into advanced economies. They have improved their financial systems, property rights, policy frameworks, and growth models. As it turns out, however, the evolution was going the other way, too: advanced economies were becoming more like emerging markets. Debt was accumulating on household, corporate and bank balance sheets. Booms in real estate and parts of the corporate sector added to financial vulnerability. And policymakers were inattentive to the risks or lacked consensus on how to address them.
When the Great Financial Crisis (GFC) hit in the advanced world, investors turned to emerging markets. With their improved institutions and policies, growth was high and stable, inflation low and stable, and returns were very attractive. Most important, the 2007-2009 crisis was elsewhere! So, investors developed expertise, endeavored to evaluate the risks, and dove in.
That all seems very long ago. Today, when asked what emerging market economy they would invest in, experienced market economists are typically cautious, if not stumped. Something dramatic has happened. What is it?
While part of the explanation is country by country, the fact that few, if any, emerging markets currently shine indicates that common causes are at work. We will come to that in a minute. But before discussing the fall, it is helpful to understand the rise.
In the 1990s, emerging market countries went through a series of crises. There was the hyperinflation in Brazil in the early 1990s; the 1994 Tequila Crisis in Mexico; the 1997 Asian Crisis in Thailand, Indonesia, Korea, and elsewhere; the 1998 Russian default; and, in the early 2000s, the Argentine collapse and the Turkish crisis. The list of causes is well known. In most cases, these included some mix of poor monetary policy that led to inflation, undisciplined fiscal policy that led to increases in debt, and unsustainable exchange rate policy that led to high current account deficits and large external debts.
Meanwhile, the central and eastern European countries were shedding their communist past. They built democracies and market-based institutions from the ground up, typically enduring huge adjustments in the process.
So, as the new millennium dawned, emerging economies looked to have taken these crisis and adjustment lessons to heart and reformed. The economic indicators in the table below are just one way of telling this story. Growth rose, inflation plunged, current accounts swung from deficit to surplus, foreign exchange reserves skyrocketed (even excluding China), and the share of global exports more than doubled.
Key economic indicators for major emerging market economies, 1990-201
Averages are GDP weighted. Countries included are Argentina, Brazil, Chile, China, Colombia, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, Saudi Arabia, South Africa, Thailand, and Turkey.
* Data show the average for the period 2011 to 2014. Sources: IMF, World Bank and authors’ calculations.
When the GFC hit in 2007, the emerging world was ready. While equity markets in the United States and Europe collapsed, and interest rates plummeted, EME growth held firm. From 2007 to 2012, China GDP grew at an average rate of more than 9%, India at close to 7%, Indonesia at 6%, Peru at 6½%, and even Turkey managed 3% growth. Buttressed by rising commodity prices, and encouraged by near-zero interest rate policy and low growth in the advanced world, investors piled in to the tune of $300 billion per year in cross-border portfolio flows.
That pattern has now reversed, reflecting the slowdown of global growth, plunging commodity prices, currency shocks, and the prospect of U.S. monetary policy tightening.
The economic slowdown is the key challenge. To be clear, the world economy is not contracting. But the deceleration has important implications, with China central to the story. Instead of the 10% growth prior to the crisis, the pace of China’s expansion appears to have slowed to less than 7% – including a larger slowdown of industrial production.
China affects other EMEs both through its impact on commodity prices and through exchange rates. It is the largest user of raw materials in the world, so its greater-than-anticipated slowdown has a material impact on commodity demand and on prices. Many EMEs are commodity exporters. Some are oil producers, while others export a combination of grains, metals and minerals. These countries benefited greatly from the more than three-fold surge of commodity prices during the 2000s. Now, they are enduring the unpleasant consequence of the price collapse. For example, energy prices are less than half what they were just one year ago.
As for the exchange rate, China’s real effective exchange rate (REER) rose by nearly 60% over the past decade (see chart). During this same period, a GDP-weighted-average REER of the largest EMEs excluding China has been roughly constant. Yet, as we discussed in an earlier post, with China relaxing capital controls, the RMB appears poised for a significant depreciation. This is bad news for the competitiveness of China’s EME export rivals, unless their currencies also depreciate further.
Real Effective Exchange Rate: China vs. other large EMEs (June 2005 =100), 2000- July 2015
Note: The weighted average is based on the average GDP-weight from 2000 to 2014 for the list of countries in the preceding table, excluding China. Sources: IMF, BIS and authors’ calculations.
Added to these common global challenges is the prospect of rising U.S. interest rates. The easing that began with the FOMC’s interest rate cut in September 2007 ended with its final net purchases of securities in October 2014. And, with the sustained improvement in U.S. employment comes the anticipation of a cycle of interest rate increases.
While the ECB and the Bank of Japan are continuing to ease policy, changing expectations for U.S. interest rates have altered relative investment prospects fairly dramatically, helping to spur the reversal of the cross-border capital flows of several years ago. Now, it is the EMEs that look relatively less appealing, so the funds are moving out. Large currency swings have accompanied this reversal. Again, it is the flip-side of what happened between 2007 and 2012. Over the past year alone, the dollar has appreciated by 25% to 50% against major EME currencies (with the notable exception of China).
As we argued in a recent post, the tightening of U.S. monetary policy and the rise of the dollar have important effects on the rest of the world. For EMEs, the problem is compounded by the fact that, in recent years, the quantity of foreign-currency-denominated debt issued by nonfinancial corporates has risen from a total of roughly $800 billion in 2003 to well over $3 trillion today (see here). With the depreciation of their domestic currencies, these issuers are now coming under substantial strain. The risk is that this stress will spread to domestic banks and sovereigns.
To be sure, local factors also play a role in EME outflows. Countries differ in their exposure to specific commodities like oil or copper. Brazil suffers from bad management and Turkey from heightened political uncertainty. Sanctions are hurting Russia, while criminal violence damages Mexico. But the common global drivers are typically more important than these idiosyncratic ones in explaining investors’ lost appetite for emerging market assets. Relative returns have fallen and risks have gone up. That explains much of what we see.
As is so often the case, we have been here before. During the episodes of free capital flows beginning in the 19th century, global capital markets have been characterized by large swings, with flows to emerging markets expanding and then reversing (see here). In the 19th century, the United States was a prime destination of these flows. Today it sits at the other end of the seesaw. The common drivers – including changes in growth prospects, commodity prices, and advanced economy interest rates – are pretty much the same.