Emerging markets: will growth continue? 23-Oct-16
The current good times will be followed by more turbulence and economic pain for the developing world.
After three years of lagging behind developed peers, emerging markets showed a burst of energy in 2016, with the equity index MSCI EM (Morgan Stanley Capital International Emerging Markets) returning 15 percent year-to-date compared with Developed Markets benchmark of 3.3 percent.
Emerging markets bonds and most currencies also gained value against the dollar and euro. According to the Institute of International Finance, excluding China, where outflows continue, emerging markets received $120bn of financial capital by the end of September, a 20 percent increase in 2015.
Several things played supporting roles in the rally. Negative bond yields on large country debt, a jump in oil prices, stabilisation of the Chinese economy and the never-ending postponement of Fed rate hikes deserve due credit.
Yet, the main driver of the emerging markets’ rally is better growth prospects, which render assets cheap. According to the International Monetary Fund, Emerging economies will grow collectively by 4.2 percent this year, and 4.6 percent in 2017, compared with the developed economies, which would chalk up 1.6 percent and 1.8 percent respectively.
However, faster growth in emerging economies sounds counter-intuitive for several reasons. The frustration of growth expectations can have severe implications for the fragile world economy.
Tapering and Fed rate hikes: Negative bond yields in Japan and the eurozone coupled with very low fed funds rates in the United States is one reason why emerging market bonds and currencies performed this well in 2016, but there is no guarantee that this situation will last in 2017.
The Bank of Japan has already adopted a stance to fix long-dated bond yields at 0, while there are rumours that the European Central Bank might taper its bond-buying programme by March 2017.
“Finding funding in hard currencies will become more expensive for emerging markets and their assets will become less attractive vis-a-vis developed markets.”
The American economy is hit by the oil shock and uncertainty related to the presidential elections, but according to the IMF it should accelerate in 2017, which should allow the Fed to go ahead with a rate hike in December and two more in 2017.
In other words, finding funding in hard currencies will become more expensive for emerging markets and their assets will become less attractive vis-a-vis developed markets.
Oil bonus is exhausted: Many emerging economies are oil exporters, with the bump in the price of Brent from the 2016 trough of $25 a barrel to $50 providing relief to external balance of growth.
But, the momentum provided by oil is unlikely to be there in 2017. According to IMF forecasts, the average price of Brent will only rise from $43 a barrel to $51 in 2017, slowing down the pace of growth.
And, China will be no help. The stabilisation of the Chinese economy, a major importer of commodities and semi-finished goods from emerging economies has helped their growth prospects substantially in 2016.
Yet, Chinese growth is driven by fiscal and monetary stimulus, which has reached its limits.
Further use of these tools could lead to asset bubbles and painful re-adjustments later on. Cautious of new imbalances, Beijing will not accelerate growth in the coming years, and might even slow down. This means emerging economies will not receive a demand boost from the Chinese economy. The optimists argue that loose monetary policy in reserve money countries and large inflows of cash into emerging economies allows their central banks to cut interest rates, thus stimulating growth.
This is a text book view which fails to work in the real world, because of the huge debt accumulation by companies and to a lesser extent households.
The recent UN Conference on Trade and Development Report says: “According to the Bank for International Settlements, the debt of non-financial corporations in these economies increased from around $9 trillion at the end of 2008 to just over $25 trillion by the end of 2015, and doubled as a percentage of gross domestic product – from 57 percent to 104 percent – over the same period. Past experience shows that if much of the non-performing private sector debt is large and denominated in foreign currency, as in Latin America, for example, it tends to end up on the public balance sheets, thus risking a sovereign external debt crisis.”
With such stretched balance sheets, companies are unlikely to borrow more and invest even if interest rates are lower. In other words, in Emerging Economies, too, monetary policy is losing is effectiveness.
Global trade is collapsing: Many emerging economies have export-led development policies, but global trade is collapsing. The World Trade Organisation recently lowered its 2016 trade growth forecast from 2.8 percent to 1.7 percent. The organisation is ambivalent about 2017; it expects 1.8 to 3.1 percent compared with 3.6 percent earlier.
Many experts would suggest that the lower bound of the prediction is realistic because of the structural changes in the world economy, such as protectionism and lower supply chains. It is very unlikely that emerging economies will supplant domestic consumption for diminishing export revenues.
In the end, the case for faster growth in emerging markets looks very suspicious on logical grounds. What if the growth expectations are frustrated?
In its latest Quarterly Review, the Bank of International Settlements says: “Nevertheless, questions lingered as to whether the configuration of asset prices accurately reflected the underlying risks.”
If growth in emerging markets doesn’t accelerate, investors are very likely to pull their funds out of these markets, triggering currency depreciation and higher interest rates. The flight of capital would be more intense if the Fed raises interest rates, or the European Central Bank tapes its bond purchase programme. The combination of higher rates and a weaker currency would feed into real sector activity, causing higher inflation, corporate bankruptcies and lower growth.
It is very difficult to say that emerging markets are around the bend for good. It is more likely that the current good times will be followed by more turbulence and economic pain for the developing world.