Thursday, November 27, 2014

How Fragile are Emerging Markets?

CAMBRIDGE – Emerging-market equities and exchange rates are again under severe downward pressure, but are the underlying economies really as fragile as global traders seem to fear? The short answer, for a few, is probably “yes,” but for most, “not just yet.”

For most countries, what we are seeing is a recalibration as investors incorporate the risk that China’s GDP might rise more slowly, the US Federal Reserve might start tightening monetary conditions more quickly, and policy backsliding in many countries might undermine potential growth. At the same time, Europe’s massive shift to a trade surplus (a key factor underpinning the region’s new-found stability) and the Japanese yen’s sharp depreciation are among myriad factors squeezing countries seeking to rein in current-account deficits.

It seems like only yesterday that Goldman Sachs analysts were celebrating the growth miracle of the “BRICS” (Brazil, Russia, India, China, and South Africa) and the International Monetary Fund, in its April 2013 World Economic Outlook, was forecasting a three-speed global recovery led by emerging markets.

What happened? The most popular culprit is the Fed, which has begun to taper its highly experimental policy of “quantitative easing,” or purchases of long-term assets aimed at supporting growth beyond what could be achieved with zero nominal interest rates. But the Fed’s role is almost certainly overblown.

For one thing, the Fed’s retreat partly reflects growing confidence in the US economy, which should mean a stronger export market for most emerging economies. Moreover, the Fed’s modest tightening is being matched by a trend toward looser monetary policy in the eurozone and Japan; so, overall, advanced-country monetary policy remains highly accommodative.

Uncertainty over China’s growth path is more fundamental. For more than a decade, China’s stunning growth has fueled a remarkable price boom that has flattered policymakers in commodity-exporting emerging markets from Russia to Argentina. Remember how the Argentines were able to thumb their noses at the pro-market “Washington Consensus” in favor of an interventionist “Buenos Aires consensus”?

Now, not so much. China’s near-term growth is an open question, as its new leadership attempts to curb the unsustainable credit-fueled boom. Until recently, global markets had not seemed to recognize that a growth recession was even a possibility. Certainly, if there ever is a pause in China’s heady growth, today’s emerging-market turmoil will seem like a mere hiccup compared to the earthquake that will ensue.

There are other notable, if less consequential, fundamentals in the mix. The shale-gas revolution in the US is changing the global energy equation. Energy exporters such as Russia are feeling the downward pressure on export prices. At the same time, hyper-low-cost energy in the US is affecting Asian manufacturers’ competitiveness, at least for some products. And, as Mexico reforms its energy sector, the range of pressures on Asian manufacturing will expand; Mexico is already benefitting from cost pressures in China.

Japan’s Abenomics is also important for some countries, as the sharp depreciation in the value of the yen puts pressure on Korea in particular and on Japan’s Asian competitors in general. In the long run, a Japanese resurgence would, of course, be beneficial to the region’s economies.

Stability in the eurozone has been perhaps the single most important positive factor underpinning market confidence in the last year. But, as periphery countries move into current-account balance and northern countries such as Germany run massive surpluses, the flip side has been deterioration in emerging-market surpluses, heightening their vulnerabilities.

At the core of emerging-market problems, however, is policy and political backsliding. Here, there are significant differences among countries. In Brazil, the government’s efforts to weaken the central bank’s independence and meddle in energy and lending markets have harmed growth.

Turkey is suffering acute challenges to its democratic institutions, as well as government pressure on the central bank. Russia’s failure to develop strong independent institutions has made it difficult for an entrepreneurial class to emerge and help diversify the economy.

In India, central-bank independence remains reasonably strong, with the Reserve Bank of India now mulling a move to an inflation-targeting regime. But a sustained period of populist policies has weakened trend growth and exacerbated inflation.

Nevertheless, some emerging markets are moving forward and stand to benefit from the turmoil if they are able to stay the course. Aside from Mexico, countries such as Chile, Colombia, and Peru are well positioned to gain from investments in institution-building. But, of course, new institutions can take decades, and sometimes longer, to consolidate.

So, overall, how fragile are emerging markets? Unlike in the 1990’s, when fixed exchange rates were widespread, most countries now have shock-absorbing flexible rates. Indeed, today’s drama can be interpreted, in part, as a reflection of these shock absorbers at work.

Emerging-market equities may have plummeted, but this, too, is a shock absorber. The real question is what will happen when the turmoil moves to debt markets. Many countries have built up substantial reserves, and are now issuing far more debt in domestic currency. Of course, the option of inflating away debt is hardly a panacea. Unfortunately, there is surely more drama to come over the next few years.

Read more from "Submerging Markets?"

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (3)

    Please login or register to post a comment

    1. CommentedProcyon Mukherjee

      In the developed world where real interest rates are negative, it is clear that too much money is held by the creditor, while in the other part of the world where these rates are positive there is still some semblance of balance that interest rates, like the old Keynesian definition, holds good to act as the link between supply and demand of money. Interest rate as a tool has somewhat failed therefore to modulate flow.

      In your book ‘This time is different’, you had delved into the topic of where does capital move to and what are the imponderables for such movement. It may seem trivial that it should move to areas where marginal product of capital is higher, but that is not the most potent reason; it is the presence of foundational pillars like good governance, presence of institutions or sophistication of markets that attract capital to a place. On this count the emerging markets have failed somewhat to make the capital ‘stay’ entrenched in invested assets once it had moved; this is where the fragility lies.

    2. CommentedMichael Holt

      Ken Rogoff's article provides some much needed perspective. I agree with his argument that many have been fixated on the potential amount and timing of a taper in the Fed's QE program, but there are many other factors to consider when asking:
      1. What's happening?
      2. What does it mean?
      3. What, if anything, do each of us need to do about it?

      In the past, it seemed that Question 1 was getting all the attention so effectively had been addressed, and that Question 2 was the stumbling block. But, then it seemed that Question 1 was not even being answered correctly due to attention being focused too narrowly on the Fed. This article helps to at least answer Question 1. And the answer to Question 2 may require answering another question, namely... "How Fragile are Emerging Markets?"

      Will we continue to see slower growth and even turmoil in emerging markets? So far, this has led to capital flowing from emerging markets to developed markets, but are their contagion risks that, rather than making developed markets more attractive, could put developed markets at risk as well?
      If only we could answer Question 2, then Question 3 might answer itself.

    3. CommentedProcyon Mukherjee

      Kenneth Rogoff has posed some new questions; the fragility of the emerging markets is once again put to test for the umpteenth time but does it leave the developed any better?

      The central issue happens to be China and if the slowdown moves in the trajectory it is destined as per all the indicators submerged in a roil of unsustainable credit growth, the excess capacity it has already amassed and added to it those that are on the anvil, would be sufficient to orchestrate a run on the debt markets as the problem would not remain confined within the shores of China.

      Or is it that China would once again surprise us?