Turn for the worse?
With emerging market growth slowing, are we en route to another financial crisis?
In September, in a speech to the Chamber of Commerce in Portadown, Andy Haldane, the Chief Economist of the Bank of England, warned that we could be moving into the third stage of the financial crisis: the emerging market crisis of 2015.
The financial crisis that began in 2008 was caused by a build-up of global liquidity, which in turn inflated, then deflated, capital flows, credit, asset prices and growth in different markets and regions. This pattern, suggested Haldane, shares many similar characteristics with what is happening in emerging markets now.
Immediately after the crisis, more than $600 billion of capital moved out of crisis affected developed markets, straight into emerging markets. As capital moved, growth followed. Since 2010, annual growth in these developed countries1.
In fact, emerging markets have accounted for 80% of global economic growth in the past five years, with China alone accounting for half1. It could be said that China’s rapid growth effectively bailed out the rest of the world from the global financial crisis as demand from China fuelled sales at Western companies and kept commodity prices buoyant. However, this came at a cost. China’s rapid boom was fuelled by trillions of dollars of debt as its domestic companies invested – particularly in infrastructure– while restrictions on individual borrowing were gradually eased. ‘There has been a credit bubble of epic proportions in China,’ observes Neil Shearing, Chief Emerging Markets Economist at Capital Economics. ‘I’ve never seen credit flood in as fast as it did into China over the past seven years.’
Since March 2014 the cycle has turned, with more than $300 billion of capital, on official estimates, flowing out of emerging markets. The commodity price cycle has now turned downwards, hitting those countries that are heavily dependent on commodity exports, such as Russia and Brazil, while benefiting net importers.
Moreover, as Haldane observes, where money has led, growth has followed. But now that growth is slowing down. Indeed, the International Monetary Fund expected emerging market growth to have slowed to below 4% in 2015, marking the fifth consecutive year of declining growth. This has come on top of the downturn in the commodity price cycle, high levels of debt, political instability and the likelihood of a rise in US dollar interest rates (the US currency also being the one in which most emerging markets borrow). It could, Haldane suggests, create the perfect emerging market storm.
So are investors right to be wary of emerging markets? While the slowdown in growth is undoubtedly a concern, the prospect is already reflected in financial markets. This has been particularly noticeable in China, where shares on the Shanghai Stock Exchange lost almost half their value between June and September 2015. This followed a prolonged rise and, even after that precipitate fall, the market is still ahead of where it was in the summer of 2014. There are also lingering concerns about the veracity of Chinese economic statistics. Yet China’s efforts to move away from an export- and investment led economy to one more dependent on domestic consumption is essential for its economic development. It is a significant transition, so some volatility on the path is only to be expected.
‘China’s population is twice as large as that of Europe and the US combined, so individual sectors can still grow,’ says Shearing. He compares China with California in the 1990s: as the US recession hit the rest of the country’s economy, California continued to prosper. Each region of China is so disparate, argues Shearing, that it is difficult to draw meaningful conclusions about the whole and apply it to the parts. Indeed, it is this very diversity within developing markets that makes it even harder to generalise about them.
Polina Kurdyavko, Co-Head of Emerging Market Debt at BlueBay Asset Management, believes that markets are underestimating the prospects of long-term growth in many developing economies and failing to differentiate between the good and the bad stories.
‘For example,’ she says, ‘Mexico has a robust reform agenda and strong legal framework, which we believe would make the implementation of future infrastructure programmes successful. We also like countries such as Chile, which has a very high level of corporate governance combined with a supportive policy framework.’
Kurdyavko thinks that while the commodity price cycle does have an influence on the outlook for individual countries, other factors can be more significant. ‘[India is] a commodity importer, which has seen strong progress on the reform agenda and has therefore been a favourite destination for a lot of investors.
However, in the case of Turkey, the country has not benefited to the same extent from weaker commodity prices because of structural and domestic issues and a government framework that is not supportive for the economy.’
The emerging market crises of the 1980s and 1990s, and the structural reforms that followed, combined with their rapid growth and integration into the global economy, mean that developing countries have become much more diverse. Wealthier countries such as Korea, with its successful manufacturing and biotech industries, are hugely different from those in sub-Saharan Africa or Latin America, where financial and political instability might threaten the whole fabric of society. ‘Thirty years ago,’ Shearing adds, ‘a lot of the economies we would now regard as emerging were in very similar positions. Many of the structural issues were the same.’
The very fact that the US has begun to raise its interest rates is a sign that it is on a more secure financial footing. It could be seen as a good thing since it indicates that the world’s financial markets can finally start to return to normality after more than seven years of financial turmoil. For the past two years, emerging markets should have also taken measures to prepare for higher US rates, such as by hedging currencies.
Haldane himself said in his speech that he believed there was evidence to suggest that this time we might be lucky, and avoid the third stage of the financial crisis after all. Emerging markets may not grow as fast as they have been but in most cases growth is still respectable.
1 http://www.bankofengland.co.uk, September 2015
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