Monday, December 8, 2008

Emerging Markets: Rise And Decline Of A Fairy Tale?

In some ways a quick look at look at the Reuters/Jeffries CRB commodities index (see below) says it all. The accompanying chart - which shows the evolution of this index from the mid 1990s to date - immediately makes a number of important details about what just happened incredibly clear. In the first place we can see how, after long languising idly around a mean, a secular rise in commodity prices starts up around 2002 and last for around four years, eventually flattening out from between 2006 to mid 2007, and then we can see a further strong surge forward in and a sharp spike upwards. Of course, after the rise always comes the fall, and this sudden and dizzying spike was in its turn followed by a pronounced downward crash, under the weightof which we are still labouring at the time of writing. In fact the index hit an all-time series high of 473.518 on 2 July 2008, and was stuck down in the low 200s as 2008 drew to a close.

Now, depending on how you see things, you will put one interpretation or another on all this. What follows is simply my own intepretation, and doubtless others will have theirs to offer. But what I personally find most interesting, indeed intriguing I would say, is just how that initial flattening-out of the trend coincides (more or less) with the arrival of the housing slowdown in the US (and thus arguably with the begining of the end for this most recent business cycle), while the subsequent 2007 spike would seem to be a clear a knock-on consequence of the start of the August sub-prime "troubles" in the summer of 2007, reflecting the sharp capital outflows into the growth thirsty emerging markets that this first world financial shock precipitated. Well, all of this should give us plenty of food for thought, as should the rout in commodity prices which followed the arrival of the July 2008 peak, a peak which anticipated by almost two months the dénouement of the financial crisis with Lehmann Brothers bankruptcy in September.

More Than Just A Commodities Boom

So, amidst all that coupling, recoupling, decoupling, uncoupling rhetoric, might it not be interesting at this point to ask ourselves just what has been happening here? For my part, the first point I would like to make is that the chart does seem to offer us some evidence to support the idea that there was some form of long term structural break in the growth path of some key emerging economies following the aftermath of theAsian crisis of 1998. As can be seen from the long term trend in commodity prices, something was finally starting to move in the world of emerging economies, and the big question is why this was.

And then we have the end point, in 2008 when, as the IMF World Economic Outlook put it “the world economy entered new and precarious territory”. Perhaps the most remarkable feature of the whole recent situation have been the marked contrasts between booming commodity prices on the one hand and developed economy credit-market collapses on the other, between the buoyant growth being clocked up in many emerging economies and the incipient recessions which were emerging in the US, Europe and Japan.

The point to note here is not just that a significant group of investors and their fund managers were busily adapting their behaviour to changed conditions in the US and Europe, but rather that a very novel problem set began to emerge, as the credit crunch wended its way forward and property markets drifted off (at best) into stagnation in one OECD economy after another. Almost overnight it suddenly started "raining money" in one emerging economy after another as foreign exchange came flooding in (as can be seen in the Indian case in the chart below) and the question became not how to attract funding, but rather how to avoid an excess of it, with Thailand even attaining a certain notoriety by imposing capital controls with the rather novel objective of trying to stop funds entering the country.

But then suddenly things moved on, and night became day as the fund flow started reversed just as quickly as it had arrived, after one emerging market economy after another began to wilt under the growing strain of sharply rising inflation. The EM "mini-bubble" burst and at the time of writing the immediate future does not look exactly bright with growth rates being locked into an ongoing cycle of repeated downward revisions. By November the IMF had cut its global growth estimate for 2009 to 2.2 percent from 3.7 percent for 2008. The World Bank went even further, and in an early december forecast projected that world trade would fall in 2009 for the first time since 1982, with capital flows to developing countries being expected to plunge by 50 percent. The Bank even forecasts that the global economy will only grow by 0.9 percent in 2009. If these dire forecasts are realised we will have the slowest pace of global growth since 1982, when global economy only grew by 0.3 percent. According to the Bank forecast developing countries will only grow by an average of 4.5 percent next year (a pace that many economists consider equivalent to a recession, given that many developing countries need to grow rapidly in order to generate enough jobs to assimilate the large numbers of young people arriving on the labour market) and even this may turn out to be excessively optimistic, depdending on how rapidly the turn around comes.

The volume of world trade, which was up by 9.8 percent in 2006 and by an estimated 6.2 percent in 2007, is forecast to contract by 2.1 percent in 2009. Such a drop would be deeper than the last major contraction in trade, when it dropped by 1.9 percent all the way back in 1975. Net private flows of capital to developing countries are also projected to decline, to $530 billion in 2009 from $1 trillion in 2007. The loss of such capital will obviously sharply constrict investment in emerging-market economies, and annual investment growth is projected to slow to 3.5 percent in 2009 from 13.2 percent in 2007.

Having said this, and while fully recognising that the future is never an exact rerun of the past, and especially not of the most recent past, given that emerging economies have been the key engines of global growth over the last five years, is there any really compelling reason for believing they won't continue to be over the next five? Could we not draw the conclusion that what was "unsustainable" was not the solid trend growth which we were observing between 2002 and 2007, but rather the excess pressure and overheating to which the key EM economies were subjected after the summer of 2007?

According to IMF data, the so called BRIC countries actually accounted for nearly half of global growth in 2008 - China alone accounted for a quarter, and Brazil, India and Russia were responsible for another quarter. All-in-all, the emerging and developing countries combined accounted for about two-thirds of global growth (as measured using PPP adjusted exchange rates) . Furthermore, and most significantly, the IMF notes that these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002”.

But behind the recent EM phenomenon what we have is not only a newly emerging growth rate differential, there is also a large scale and ongoing currency re-alignment taking place, a realignment which is being driven by those very same growth rate differentials. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and a declining dollar) has meant that a convergence in global living standards - at least in the cases of those economies who are experiencing the strongest acceleration - has been taking place much more rapidly than anyone could possibly have dreamed back in the 1990s, even if the long term importance of this is currently being masked by the recent collapse in commodity values and the downward slide in emerging currencies associated with this and the wekening in risk appetite. But the impact is there and is very well illustrated by the case of Turkey, as can be seen in the chart below.

Of course there is upside and downside here, and alongside the steadily rising importance of the BRIC and other developing economies we have witnessed a significantly weaker role for "home grown" US growth. In 1999 the US economy represented 30.91% of world GDP, and in 2007 this percentage will be down to 22.4% (on my calculations based on the forceast made by the IMF in October 2007). In 200 the US economy accounted for a staggering 40.71% of global growth, and by 2007 this share is expected to be down to 6.43%.

Slow Growth In The Credit Boom Driven Economies

So what does the future have in store for us? Well the recent pronounced fall in global economic activity, coupled with the collapse of commodity prices and inflation rates, has evidently reawakened deflation fears, and monetary policy, at least in the United States and Japan, looks set to be very very loose indeed, which bring only one word to my mind in an emerging markets context "carry".

While the economic and financial world as we know it is far from at an end the present global recession surely looks set to be both long and severe, certainly by recent historical standards in the OECD world. 2009 promises to be hard all round and if we are to see a new self-sustaining global expansion getting underway then it is hard to see where the momentum for this will come from if it is not from the emerging economies.

This is doubly true, since following the credit and current account excesses of recent years a number of the richer economies will undoubtedly suffer from a sustained period of low growth as private consumers and corporates steadily deleverage from the very high levels of debt they have accumulated, while their national governments will find themselves forced to adopt a more restrictive fiscal posture as they pay down the extra debt acquired in the course of the bank and financial system bailouts. And those larger economies who did not accumulate such excesses, like Germany and Japan, will undoubtedly notice the lack of customers for all those exports on which growth in their economies depends.

This recession then marks the end of the era where a few of the richer OECD economies assumed the role of the global consumers of the last resort, with the "counterparty" countries playing the role of net producers and bankers of the last resort, in terms of their willingness to fund the associated ongoing current account deficits.

Export Driven Ageing Economies No Global Drivers

So the really key question we all now face, as one heavily indebted economy after another tries to turn itself into an export driven growth miracle, is who is going to play the part of consumer in this new world, and who is going to assume the inevitable current account deficits which will be generated in the process? Clearly the golbal net current account balance is a zero sum game, since we can't all run surpluses at one and the same time. All the recent efforts to translate high national savings rates in Japan and Germany into stronger consumption have been futile will become even more futile now given that these countries have rapidly aging and declining populations, and you simply can't go round with a shotgun and try to force people to consume when what they are really worried about is the sustainability of their pension. So the main industrial economies are at this point either too stretched financially or too old and sclerotic to offer the energy and consumer dynamic needed to lead the next long-term expansion. What they can, evidently do, is provide the credit and all the machinery and equipment which can be bought with it to allow others to start producing and hopefully then consuming.

BRICS Split In Two

So rather than looking towards ageing economies like Germany and Japan, a rather more plausible source of global demand is likely to be found in the still largely untapped consumption potential of the growing middle classes in the big emerging-market countries. The needs and tastes of Chinese, Indian and Brazilian middle-class families seem to be well positioned to replace consumers in the U.S. , the UK, Spain and elsewhere, who at least in the near term will be restrictively focused on trying to straighten-out their severely strained balance sheets. However the earlier categorisation of the four leading emerging economies into one single group simply on the basis of the size of their populations can now be seen to have been overly simplistic. While all four BRIC countires look set to slow considerably in 2009, , Russia and China seem to single themselves out from the group as having rather more serious corrections in front of them.

At the time of writing the IMF still projects China’s growth in 2009 as running at around 8.5 percent, although as they suggest, with exports likely to fall sharply and the property sector weakening, risks here are firmly tilted to the downside. My own feeling is that as we move forward there will be significant downward revisions to the outlook, and that we may well even see negative growth in Russia's economy in 2009, and China growth in the very low single digits. Numerous issues now raise their heads in the case of both these two countries - stretching from their very special demographic profile, to the quality of their democratic institutions, to their ability to respond flexibly to what are inevitably very complex economic policy needs, to the whole foundation of their export (China) and commodity (Russia) driven growth models. In this sense I feel the next growth wave will see a fissure in the BRIC camp, with India and Brazil increasingly singling themselves out as poles of stability in what would otherwise be a fairly unstable world of emerging economies.

It's The Demography Silly

Basically the what I have argued above only depends on one simple premiss, that in the world of economics demography matters, and it matters a good deal more than many imagine. If we want to understand why it is that so many EMs have been finally emerging over the last decade, then, apart from the greatly improved institutional quality we are seeing, the fact that many of these countries have been passing through the most favourable stage in their demographic transition is surely not incidental. Equally, given that this transition is having a differential impact on countries at one stage or another I would suggest that the export dependence of a new group of elderly economies - lead by Germany and Japan - can equally not be understood without some reference to their demographic profile.

And if this sort of argumentation has any validity at all, it is bound to have implications for one of the key problems which we will face in the context of the next global upturn: what to do with the financial architecture which we have inherited from the original Bretton Woods agreement (or Bretton Woods II as some like to call it). The limitations of the current structure have become only too painfully apparent during the present recession, since with both the Eurozone and the US economies contracting at the same time, the currency see-saw between the dollar and the euro has failed to provide any adequate form of automatic stabiliser. And Japan is in an even more parlous state, deep in recession, and desparate for exports, it is having to live with a yen-dollar parity which is at levels not seen since the mid 1990s. The issue is in many ways similar to the one relating to who it is who will run the current account deficits and do the necessary consuming during the next upturn. Evidently the main problem we have seen in the last business cycle has been the size of the imbalances which have been run up, and policy decisions are urgently needed to impose measures and structures which help avoid a repeat of the same in the near future. But there is also the question of the basket of reserve currencies to be held by central banks, and this basket now badly needs widening, at the very least to take account of the new global role to be played by Brazil and India by opening these baskets to the two leading emerging economy global currencies.

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