The spotlight has again fallen on structural issues in emerging economies over the past few weeks, particularly those running large current account deficits including India, Indonesia, Brazil, South Africa and Turkey. This has been sparked by a number of issues including the lead in to the January meeting of the Federal Reserve, renewed concerns about growth and financial stability in China and unrest in two frontier markets; political turmoil in the Ukraine and financial stresses re-emerging in Argentina.
Concerns first emerged in mid-2013 as financial markets
contemplated the imminent reduction in the pace of US Federal Reserve asset
purchases, the subsequent reduction in global liquidity and the ability of
emerging market deficit countries to attract the necessary capital to fund
those deficits in an environment of rising developed market interest rates.
So the spotlight is again on the need for structural
reform in emerging economies. Regular
readers of this blog understand the need to attend to structural reform is not
just an issue in the post-GFC developed economies. The need is just as great, albeit different,
in the key emerging economies.
The objective is a need to rebalance global growth and
reduce the structural imbalances that were the genesis of the GFC (the “savings
glut”). To rebalance growth (more
precisely final demand) and reduce imbalances the large surplus countries such
as Germany, Japan and China, needed to rebalance away from exports to
consumption so that the large deficit countries such as the United States,
non-Germany Europe and India could boost
competitiveness and grow exports. Progress
has been made in some countries although it remains to be the seen the extent
to which these improvements are structural (permanent) or cyclical (temporary).
The emerging economies have just as a big a role to play in
reducing imbalances as the developed economies.
That said we don’t need to see an elimination of global imbalances. Current account deficits are not a bad thing
so long as they represent an efficient allocation of savings between surplus
and deficit countries.
Current account deficits are the gap between savings and
investment. Emerging markets have high
investment needs but typically low wages and low domestic savings. Developed economies on the other hand
typically have higher wages and savings and lesser investment needs so lend
their savings to deficit countries, for a return of course.
The issue for us is not so much the deficits themselves
but rather the use to which those funds are being put. It’s the quality of the investment that will
ultimately determine the willingness and ability of saver countries to continue
to fund those deficits.
Of course structural reform and the benefits that flow
from it is a long-term game. In the near
term it’s the commitment to reform that’s important. In some respects emerging market economies
are doing a better job than some of the developed economies.
In the Euro area and the United States it took a sense of
crisis to see progress. We have already
seen an ambitious reform program announced in China, although details on
implementation remain sketchy. India has
taken action to remove roadblocks to investment. The Project Monitoring Group has been
successful in unlocking investment projects worth an estimated 3.5% of
GDP. Furthermore the Reserve Bank of
India has adopted the recommendations of the Urjit Patel Committee which
strengthens their commitment to achieving greater stability in prices. However, we are more concerned about the
commitment to reform in Brazil.
As we said last year we don’t see a re-run of the Asian
Financial Crisis. Exchange rates are
typically more flexible and have been falling, foreign exchange reserves are
higher and external debt is lower.
The bad news is that the lower exchange rate adds to
already high inflation in some countries such as India. We’ve also said at times that the biggest
near-term risk for emerging markets is that central banks don’t take the threat
of inflation seriously.
On that front central bank action has been
appropriate. The Reserve Bank of India
has raised rates 75 bps in 4 months despite decade low growth. In Brazil the Selic rate has been moving
rate higher since April 2013. Indonesia,
South Africa and Turkey have all raised interest rates recently.
Of course higher interest rates are negative for
growth. Indeed when these issues first
emerged in mid-2013 we lowered GDP forecasts for the deficit countries in 2013
and 2014 on the expectation of higher interest rates. I’m still happy with those growth projections,
although the risk is that interest rates move higher than we anticipate leading
to softer domestic demand.
In India we think growth will be modestly higher this
year reflecting growth in exports and higher investment. We think growth will be higher in
export-dependent countries such as South Korea and Taiwan on the back of higher
developed world growth. Brazil, however,
is likely to see lower growth in 2014 than in did in 2013.
On the other hand lower domestic demand is also a
positive for current account deficits and a reduction in imbalances. We continue to believe that the current
account deficits in the “problem” countries will soon be improving on the back
of exchange rate depreciation, higher global growth and lower domestic demand. India has also taken steps to curtail the
imports of gold, although that’s not such good news for South Africa exports.
In China, recent PMI data has slowed again risking
another decline in growth this year. We
are still happy with our forecasts of 7.5% this year, down from 7.7% in
2013. That reflects higher export growth
(higher global growth tempered by further exchange rate appreciation) and
stability in consumption expenditure which will be offset by the impact of
tighter credit conditions on fixed asset investment.
We see little risk of a full-blown financial crisis in
China. Post GFC China incurred increased local government debt, a property
bubble and growth in unregulated shadow banking. The leadership is keen to unwind these
excesses but at the same time we expect they will protect the lower bound of
their growth target of 7.5%. For us that
makes a potential policy mistake the key risk in China, which is not helped by
lack of transparency of PBoC actions to rein in credit growth. The sequencing of the implementation of
reforms will also be critical.
Longer term we continue to believe dynamics in emerging
markets will see growth continue to exceed that of the developed economies on
average. Demographics, productivity and
rising middle classes will continue to contribute to relatively strong
growth. But we also need to see
commitment to reform for stability of that growth.