Market crises in developing countries are a recurrent theme in economic history. In the 19th century when the US was an emerging market, its cycle of boom and bust had, on occasion, dramatic effects in Europe.
A long series of financial disasters included state governments defaulting in the 1840s and major railway bankruptcies between 1873 and 1893. Argentina’s crisis in 1891 left Baring Brothers, the second-largest investment house in London at the time, effectively bankrupt. It had to be bailed out by the Bank of England.
Two recent examples of widespread financial distress in emerging markets were in 1982 and between 1996 and 1998. In 1982 problems developed in Latin America, particularly in Brazil and Mexico. The previous decade had seen profligate lending by US banks to these countries. When the 1980-82 recession was triggered by high oil prices, these countries were unable to service their debts. It took almost a decade for the banks involved to recover from the balance sheet damage they suffered as a result. It took just as long for the heavily indebted countries to restore credit ratings.
The 1996-98 crises were focused in Asia, where again developing countries such as South Korea, Thailand and Indonesia became dependent on short-term foreign borrowings. Massive domestic investment that generated strong economic growth was financed by borrowing heavily abroad. When the lenders became nervous and some tried to withdraw capital, the borrowers’ currencies collapsed.
The problem started in Thailand in August 1996 and rapidly spread elsewhere. The final blow-up occurred in 1998 when Russia defaulted on its government debt. This brought down the Long Term Capital Group (LTC) in New York. The US monetary authorities had to orchestrate a bailout of LTC similar to that of Barings a century earlier.
The detailed causes of these crises differ from case to case, but all of them have similar macroeconomic characteristics. Over long periods of prosperity, the allocation of capital in an economy becomes inefficient. Strong growth masks these problems and allows excessive debt to build up. Finally, mounting inefficiencies cause growth to slow. Often this becomes manifest through rising inflation, which requires increased interest rates. Ultimately what is not sustainable, collapses.
Apart from resource bonanzas, in the long run, economic growth depends on improving efficiency and productivity. Recessions are periods in which the economy contracts, eliminating inefficiencies and forming a new base from which growth can resume. These play an essential role in achieving sustainable growth over the longer term.
Share market indices provide the simplest picture of the changing fortunes of these economies. Graph 1 shows the aggregate index for all emerging markets. The fivefold rise in prices between 1988 and 1993 was followed by a five-year decline from 1997 and 2002. The tremendous surge in equity prices in Brazil and India after 2002 reflects their recent economic booms. China offers a more nuanced picture, experiencing an asset bubble between 2006 and 2007, which was choked off by government intervention.
The expansion of emerging markets after the 1982 meltdown lasted 12 to 14 years. We are now in the 14th year since the nadir of 1998. Given previous experience, we are close to or at the point where after a decade of astonishing growth, emerging markets should enter a period of adjustment. The current slowdown in China, India, Brazil and other emerging markets must be viewed within this context.
In 2009, in response to the world financial crisis, China pumped huge sums of money, equivalent to more than 30 percent of its gross domestic product (GDP), into state-owned enterprises and regional governments to boost infrastructural investment. The state-controlled banking system was instructed to open the lending taps, leading to a rapid recovery of China’s economy, and counteracting the adverse consequences of a collapse in world trade. The problem was that the programme worked too well, creating an overheated property market and rising inflation. Since 2010, the Chinese government has been battling to regain control of the economy.
Direct measures, such as restricting the growth of credit, are starting to work and growth has slowed towards the government’s longer-term target of 7 percent. However, the normal symptoms of an over-indebted society are becoming visible. When debt levels are too high, investment slows because the focus of the borrower shifts from business expansion to repairing balance sheets.
As the Chinese economy has become larger and more complex, the ability of its government to manage the economy has waned. Its economy is developing a life and will of its own, evolving from being investment driven to consumption driven. The current slowdown is part of this process. While it may be possible to use the old techniques to inject one last growth surge, the secular trend will be towards growth at a more moderate pace.
India has also been growing unsustainably, the consequences of which are seen in a deteriorating current account, a declining rupee and rising inflation. Inevitably markets are forcing adjustments to rebalance the economy to create greater financial stability. Growth is slowing. The story in Brazil and other emerging markets is similar.
Among the casualties of slower emerging market growth are the commodities markets. It looks as if we have seen the peak of the great commodity boom that commenced in 2002, and was driven by a rapid increase in demand in developing economies, especially China. Rising export prices have rewarded commodity exporters such as Australia, Chile and South Africa with a decade of prosperity. Now what has been favourable is becoming adverse. No longer will these countries be able to sit back and allow the rising tide of prices to carry them ever forward.
The prospects for South Africa are particularly worrying. While Chile and Australia have a strong skills set, which will enable them to reinvent themselves and change their focus to compensate for shrinking mining revenues, South Africa probably lacks the skills and market flexibility to do this. This is the biggest challenge our country faces because it directly affects all our other problems. How will the economy grow after the end of the commodity boom?
Since 1990, globalisation of trade has created one world market. What happens in Europe and North America has long affected what happens in Brazil or India. Now developments in emerging markets have an effect on the developed economies.
For example, the euro zone has become dependent on the prosperity of Germany, but Germany has become significantly reliant on exports to China. Emerging markets account for most of the world’s growth. The principal reason why their economies are slowing is internal and has nothing to do with Europe, America or Japan. Slower growth in Asia is one of the main causes of deteriorating global business conditions.
The success of the big monetary stimulus injected into the financial system after the Lehman Brothers collapse in September 2008 may have given rise to a prevalent illusion that the emerging markets can bounce back rapidly to their previous growth rates. Previous experience suggests otherwise, and that a slowdown such as we are currently experiencing can continue for a number of years.
However, in time all things pass. The upward secular growth trend of the developing half of the world remains intact. After a period, which may last years rather than months, growth will start accelerating again. A global slowdown can create investment opportunities for those patient enough to wait for them.
Sandy McGregor is a portfolio manager with Allan Gray.