Monday, February 3, 2014

Spotlight on emerging markets

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.