The EM’s ‘fragile 8′ must save themselves
The start of 2014 has seen the global markets decisively in risk-off mode, with global equities falling, government bonds rallying and many emerging market currencies collapsing. Yet few investors currently believe that the risk-off pattern will continue in the developed markets (DM’s) for the year as a whole. The bullish consensus for developed equities remains firmly intact, for now.
Economic fundamentals in the DM’s have not really changed. There have been some mildly disappointing data releases in the US, but these have been mostly due to an excessive build-up in manufacturing inventories since mid 2013, and the prospects for final demand seem firm.
Furthermore, the Fed’s tapering of asset purchases has now been clearly separated from its intentions on short rates, which remain extremely dovish. So far, the decline in developed market equities has been very minor compared with the rises seen last year, and do not even constitute a normal pull-back in a bull market.
In the emerging markets (EM’s), however, there is much greater cause for concern. As the graph above shows, the EM crises in the late 1990s did not, in the end, prove fatal for equities in the US and Europe, but they did cause occasional air pockets, notably in 1998. This is why investors are focused on whether the current EM crises will deteriorate further, and whether they will eventually take the DM’s down with them.
The causes of the crises are not hard to discern, and are familiar from the 1990s. After 2008, many of the EM’s tried to avoid the consequences of the Great Recession in the DM’s by adopting aggressively expansionary fiscal and monetary policies, believing that their growth miracles of the 2000s could continue.
They were pushed in this direction by the capital inflows that followed quantitative easing by the Fed. Classic, and severe, credit bubbles ensued, with current account deficits widening rapidly in a group of countries that last summer became known as the ‘fragile 5′ – India, Indonesia, Brazil, Turkey and South Africa. These five have remained fragile, and have now been joined by Argentina, Russia, and Chile. So now we have the ‘fragile 8′, and the number could grow further. (See this excellent analysis by John Mauldin.)
These countries have many differences, but they also have something in common: a requirement to improve deteriorating balance of payments positions, which are much harder to finance now that the Fed is withdrawing QE. Some of them are inclined to blame the Fed for their predicament, but this is cutting very little ice in Washington. Unlike the onset of the EM crises last summer, the latest bout has not coincided with any change of opinion about monetary policy in the DM’s.
Instead, the markets seem to be reacting to the fact that many of these countries need to undertake several difficult policy steps, all at the same time: lower real exchange rates, higher real interest rates, fiscal tightening in some, and structural reforms in many.
In other words, the economic problems of the ‘fragile 8′ are increasingly being viewed as internal to them, and there is scepticism about the ability of their political systems to deliver the necessary policy adjustments. (Paul Krugman points to the dangers of “economic populism” [1], and makes the case for restrictive policies in some EM’s, here.)
Of course, the slowdown in China has not helped the fragile group, especially those that are dependent on commodity exports. But a dangerous dynamic is now in place, familiar to those who remember the melt-down of the emerging Asian economies after the financial crisis of 1997. Then, China remained immune from the worst features of the crisis, but that did not prevent the rest of Asia from experiencing severe recessions as “sudden stops” in capital inflows forced them to adjust their balance of payments deficits very abruptly.
The decades-long consequences of these sudden stops included a decline in the investment/GDP ratio of 9 percentage points, and a drop in trend GDP growth of 3.3 per cent. (See Carmen Reinhart and Takeshi Tashiro here.) As the DM’s are now discovering, financial shocks have exceptionally long-term effects on economic performance. It is a serious mistake to expect any of this to blow over rapidly.
Optimists claim that there are grounds for hoping that some or all of the fragile group may ultimately avoid the worst fate of the Asian tigers. One difference is that exchange rates have been much more flexible during the onset of the crisis this time than they were in the 1990s, when most of the relevant economies were trying to run fixed exchange rates against the dollar.
This encouraged an even bigger build-up in external debt in the severe 1990s cases than has happened now (though many EM’s do look vulnerable on this score – see Jens Nordvig’s table on the left). And the collapse in confidence was all the more sudden, because banking sectors were much more severely exposed to the revaluation of large foreign debts.
This time, the more gradual adjustment of EM exchange rates – upwards before the crisis and downwards now – may provide a shock absorber. Still, the consequences in terms of imported inflation, declining domestic demand and imploding credit bubbles will inevitably be very challenging for policy makers, many of whom have become hubristic after the EM miracle years in the 2000s.
Some will be able to meet the challenge. India, for example, is now doing much better with Raghuram Rajan at the central bank. But others may choose to follow Argentina by refusing to accept the laws of market economics. They will be tempted to monetise the fiscal deficits that will follow economic slow-downs, thus feeding a downward spiral in nominal exchange rates. They cannot realistically hope to be rescued from this fate by “policy co-operation” from the Fed or the IMF; it is largely up to them.
Could all this develop into a major global shock? Exports to the ‘fragile 8′ still represent only 0.7 percent of US GDP, so a damaging trade shock is not on the cards. The exports of the euro area are about twice as vulnerable to the ‘fragile 8′ as the US, and a small number of euro area banks (especially in Spain) are very exposed to loan losses in the EMs. This means that there could be contagion to southern Europe, where some banks may already need to raise large amounts of new capital after the ECB’s stress tests.
But the overall consequences for the developed economies still seem largely manageable – always assuming, of course, that China does not hard land.