Thursday, August 29, 2013

Turmoil in emerging markets: NOT a repeat of 1997

One of our most often used phrases with respect to emerging markets is that while they don’t suffer the same structural problems as many post-GFC developed economies they have plenty of their own to contend with.  Events of the last few days, especially in some of the larger high current account deficit countries such as India, Indonesia and Brazil, are a recognition of those challenges as the US Federal Reserve looks to start tapering its asset purchase program.

The issue is that Fed tapering means reduced global liquidity at a time when some emerging market current account deficits have been deteriorating, admittedly for some time, requiring greater capital inflows to fund them.  It never ceases to amaze me how financial markets tend to react to current account deterioration in some countries including New Zealand; the deterioration is tolerated until, quite suddenly, it’s not.

The recent deterioration in current account balances has been significant.  I have focussed on Indonesia, India and Brazil given that in US dollar terms these deficits are amongst some of the largest in the world.

I tend to be more accepting of current account deficits in emerging markets.  From an economic development perspective it makes sense that developing countries should run current account deficits as investment is front-loaded before incomes have risen sufficiently to generate a pool of domestic savings.  But that’s only OK if what we are seeing is a gap between savings and investment rather than excessive consumption.  I am actually more concerned with some emerging country budget deficits and the high costs of domestic subsidies (for fuel for example) than I am about their current account deficits.  Of course getting budget deficits under control improves national savings which will in turn assist with the current account deficit.

But I digress.  Some have likened the current situation to a repeat of the 1997 Asian Financial Crisis (AFC).  I disagree. For a start, exchange rate regimes in Asia are typically more flexible now.  Exchange rates have depreciated significantly in recent months; the Indian Rupee is down 20% this year and the Indonesian Rupiah is down 12%.  Furthermore, banks in Asia are in better shape than they were in 1997 and foreign exchange reserves are much higher.    In South America, the Brazilian Real is down 12.5% this year.

Also, external debt is lower now than it was in 1997.  Remember the Asian economies worked hard to improve their financial positions following the AFC.  Regular readers will know I subscribe to the “saving glut” theory as the genesis of the GFC.  Strong export-led growth post the AFC led to significant current account surpluses (i.e. emerging market savings) which were “consumed” by the developed world with America acting as borrower of last resort.  Be careful what you wish for.

We think we are actually on the verge of an improvement in many emerging market current account deficits.  A number of factors will contribute to this including the recent exchange rate depreciations which will improve export competitiveness and will act as a constraint (depending on elasticity of demand) on import growth.

Of course the currency depreciation will be inflationary but that is likely to be transitory.  That said, we think it’s still likely that Indonesia raises interest rates soon and while India has raised some interest rates to support capital inflows, we think they will be back to easing later this year on the back of weaker growth and relatively contained underlying inflationary pressures.  In Brazil the central bank has been raising interest rates, the latest move a 50bp hike this morning, but we think lower growth means inflation is unlikely to reach the heights we expected just a few months ago which means interest rate increases are nearly done.

We have also progressively lowered expected growth rates in India and Brazil this year. We now see India growth at 5.6% this year with Brazil likely to come in at around 2.0%.  With respect to the current account, weaker domestic demand means less import demand.    Also remember that from global growth perspective a relatively strong Japan and stabilisation in China and Europe are providing some offset.  In fact we look for stronger growth in developed economies over the next few quarters to support emerging market export growth.

So we don’t think the current situation is anywhere near as dire as it was in 1997. Indeed we expect some improvement in emerging market current account deficits over the next few months.  However the recent angst highlights that the need for growth enhancing structural reform is not just a developed market phenomenon.  In the meantime, expect concern around key current account deficit emerging economies to linger until some turnaround in their external positions becomes clear.