Since the US Federal Reserve began talking about tapering its bond purchases last year, investors have been forced to separate the emerging market sheep – those with well-managed economies – from the goats, with their poorly run economies.
The goats include the fragile five of Brazil, India, Indonesia, South Africa and Turkey, along with Argentina, the basket-case economy. They all have growing current account deficits, weak currencies, serious inflation and falling stock markets.
The goats are forced to rely on foreign money inflows to fill their current account holes. When the money leaves, as it has in the past year, the goats find themselves in deep trouble, with no good choices. So far, the goats have raised interest rates to try to retain and attract foreign funds, but this can depress already weak economies.
The alternative is exchange controls, used by Argentina and Venezuela. That’s why Argentina hasn’t bothered to increase its central bank rate. But exchange controls can also devastate an economy.
Artificially low interest rates and soaring inflation are encouraging Argentinians to spend, not save. However, retailers don’t want to sell their goods, knowing they will have to replace inventories at higher prices – if they can obtain them.
In some ways, though, the emerging market goats are better off than in the late 1990s. Back then, many had fixed exchange rates and borrowed in dollars and other hard currencies. They didn’t want to devalue because that would increase the local currency cost of their foreign debts.
Consequently, they were vulnerable – and fell like dominoes when Thailand ran out of foreign currency reserves in 1997, touching off the Asian crisis.
Who will help out the goats? Certainly not the US. Nor is China a likely volunteer now that its growth is slowing. Japan is seeking to hike exports and reverse a negative trade balance and near negative current account. The euro zone is also unlikely to lend a hand, considering its own economic weaknesses.
Apart from the common problems of the emerging economy goats, specific countries have specific ailments. The Brazilian government, trying to support the middle class, has hired tens of thousands of new civil servants, expanded the welfare system, subsidised motor fuel and electricity prices and directed government banks to promote consumer loans.
From 2009 to 2012, consumer lending increased on average 25 percent a year, but with credit card interest rates of 80 percent or more, delinquencies are mounting. The earlier commodity boom made the consumer spending and borrowing orgy possible. Now that is over, and Brazil is not prepared to face the consequences.
Already, Brazilian consumers are retrenching. Retail sales rose 4 percent year on year last year, the weakest growth since 2003. Gross domestic product (GDP) grew only 2.3 percent last year, down from 7.5 percent growth in 2010.
In Turkey, the lira has been under pressure for a year. The hordes of money Turkey attracted during the Fed’s easy-money days are flowing out. With inflation heating up, the central bank boosted its overnight rate from 7.75 percent to 12 percent. The lira jumped before retreating.
South Africa has suffered from multiple strikes in the mining sector, which provides a third of exports, despite a quarter of the workforce being jobless. South Africa’s current account deficit hit 6.8 percent of GDP in the third quarter of last year. The rand lost 19 percent against the dollar last year and 4 percent more this year. It has tiny foreign currency and gold reserves to support it and inflation is high.
For now, all emerging markets are under pressure – and it will only get worse if China’s economy keeps slowing or its vulnerable shadow banking system collapses. When the smoke clears, the securities of the sheep economies may be cheap enough to be interesting. Still, I don’t expect growth in North America and Europe to be strong enough to absorb the sheep’s exports.
The goats may not collapse, because their government debt is mostly in local currencies, not hard currencies as in the late 1990s, and currency fluctuations may cushion the blows. They are likely to see prolonged underperformance with no meaningful revivals, but no collapses either.
* Gary Shilling is a Bloomberg columnist and president of A Gary Shilling. This is the second in a two-part series.