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Overshooting in Emerging Markets

MILAN – Until relatively recently, countries’ so-called middle-income transitions were largely ignored – in part because what was supposed to be a transition often became a trap. A few economies in Asia – particularly Japan, South Korea, and Taiwan – sailed through to high-income status with relatively high growth rates. But the vast majority of economies slowed down or stopped growing altogether in per capita terms after entering the middle-income range.

Today, investors, policymakers, and businesses have several reasons to devote much more attention to these transitions. For starters, with a GDP that is as large as the combined total of the other BRICS countries (Brazil, Russia, India, and South Africa) plus Indonesia and Mexico, China has raised the stakes considerably. Sustained Chinese growth, or its absence, will have a significant effect on all other developing countries – and on the advanced economies as well.

Second, the developed economies are out of balance and growing well below potential, with varying but limited prospects for faster growth on a five-year time horizon. By contrast, emerging economies, with their higher growth potential, increasingly represent large potential markets to tap.

Third, a majority of the large emerging economies (Indonesia, Brazil, Russia, Turkey, and Argentina, but not China) unwisely relied on large inflows of abnormally cheap foreign capital, rather than domestic savings, to finance growth-sustaining investments. As a result, their current-account balances deteriorated in the post-crisis period.

Now, with the onset of monetary tightening in the advanced economies, the imported capital is leaving, in a slightly panicky mode, creating downward pressure on exchange rates and upward pressure on domestic prices. The adjustment now underway requires launching real reforms and replacing low-cost external capital with domestically financed investment.

Market uneasiness reflects uncertainty about the duration of the growth slowdown that is likely to result, the implications for credit quality and valuations, herd effects, and the negative returns from bucking the trend. Moreover, there is concern that an overshoot in capital outflows could produce the kind of self-reinforcing damage to stability and growth from which it is more difficult to recover. These large emerging economies received an apparently free pass to growth: an ability to invest without pursuing arduous reform or sacrificing current consumption. But it is easier to take the detour than it is to return to the main road.

But this narrative is largely irrelevant to China, where excess savings and capital controls still limit direct exposure to monetary-policy externalities spilling over from advanced countries. China is not risk-free; its risks are just different.

Even so, amid growing concerns about emerging economies’ prospects, China is attracting attention because of its scale and central position in the structure of global trade (and, increasingly, global finance). As a result, risk assessment in China focuses on the magnitude of the structural transformation, resistance from powerful domestic interests, and domestic financial distortions.

In particular, there is considerable uncertainty about the Chinese version of shadow banking, which has grown in large part to circumvent the restrictions embedded in the state-dominated official system. Shadow banking has given savers/investors access to a larger menu of financial options, while small and medium-size enterprises – which play an increasingly important role in generating growth and employment – have gained broader access to capital.

The Chinese authorities need to address two issues. The first, establishing regulatory oversight, will be easier to resolve than the second: the potential for excessive risk-taking as a result of the implicit government guarantees that back state-owned banks’ balance sheets. The authorities need to remove the perceived guarantee without triggering a liquidity crisis should they let some bank or off-balance-sheet trust fail.

The list of other challenges facing China is long. China needs to rein in low-return investment; strengthen competition policy; correct a lopsided fiscal structure; monitor income distribution across households, firms, asset owners, and the state; improve management of public assets; alter provincial and local officials’ incentives; and overhaul the planning and financing of urban growth. Thoughtful analysts like Yu Yongding worry that the difficulties of managing imbalances, leverage, and related risks – or, worse, a policy mistake – will distract policymakers from these fundamental reforms, all of which are needed to shift to a new, sustainable growth pattern.

Little wonder that financial markets are feeling slightly overwhelmed. But the swing is excessive. Not all advanced-economy investors who were chasing yield have deep knowledge of developing-country growth dynamics. As a result, the trend reversal will almost surely overshoot, creating investment opportunities that were missing in the previous environment, in which asset prices and exchange rates were strongly influenced by external conditions, not domestic fundamentals.

The major emerging economies are adjusting structurally to this new environment. They do not need external financing to grow. In fact, since World War II, no developing economy has sustained rapid growth while running persistent current-account deficits. The high levels of investment required to sustain rapid growth have been largely domestically financed.

China’s challenges are idiosyncratic and different from those of other emerging economies. The structural transformation required is large, and the imbalances are real. But China has an impressive track record, substantial resources and expertise, strong leadership, and an ambitious, comprehensive, and properly targeted reform program.

The most likely scenario is that most major emerging markets, including China, will experience a transitional growth slowdown but will not be derailed by shifts in monetary policy in the West, with high growth rates returning in the course of the coming year. There are internal and external downside risks in each country that cannot and should not be dismissed, and volatility in international capital flows is complicating the adjustment.

The problem today is that the downside risks are becoming the consensus forecast. That seems to me to be misguided – and a poor basis for investment and policy decisions.

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