Emerging markets, once viewed with so much optimism, are now at the point of widespread pessimism. One does not have to look back far to find a time of unbridled optimism for emerging markets.
Unprecedented growth domestic product (GDP) growth rates, vast foreign exchange reserves, a rapidly growing middle class and a host of other arguments were used to explain why emerging markets would both drive global growth and offer the most exciting opportunities for investors.
There would be “decoupling” as emerging markets weathered whatever crises occurred in the West. And there would be “convergence” as low and middle-income countries caught up with the world’s richest nations. Books like When China Rules the World (2009) or The Emerging Markets Century (2007) captured the zeitgeist.
How different things seem today, a time of widespread pessimism about prospects facing these same countries. Emerging market growth rates are down, their currencies have plummeted and their equities have been a great disappointment – essentially flat over the past five years (+5 percent in US dollar terms) during which time developed market equities have gained nearly 80 percent. With the exception of India, where the consensus view remains optimistic, it is hard these days to find someone with a positive outlook on growth prospects in the other Brics nations – Brazil, Russia, China and South Africa.
So what happened to the emerging markets dream? What did the optimists miss? And what might the future hold?
To begin to address these questions, we need to consider both the nature of economic growth and events since the 1990s that have shaped the emerging world.
Nature of economic growth
Very simply, growth in economic output is achieved by increasing the inputs (labour, capital, human capital) and getting more out of them (productivity). Population growth, capital deepening, better education and skills, new ways of doing things and re-allocating resources to more productive activities are what drive higher economic output. Having more inputs, by saving and investing, and using them better are the determinants of growth.
But every decision taken by businesses or government is embedded in a deeper determinant of growth, loosely termed in the academic literature as “institutions”.
“Institutions” encapsulates factors like the nature of property rights, rule of law, control of corruption, the quality of regulation, labour institutions, macroeconomic policy and numerous other influences which affect the incentives people face and therefore the decisions they make.
When one thinks about the nature of growth in this way, it quickly becomes clear that microeconomic and institutional foundations play a much greater role in determining long-term growth than macroeconomic policy. Of course, countries cannot thrive without sound macroeconomic management – sustainable public debt and moderate inflation, for example – but good macro policies in themselves are insufficient to create high growth for prolonged periods lasting a decade or more.
From crisis to euphoria
Before the exuberance of the late noughties, the 1990s was littered with major crises in emerging markets: Mexico (1994), Asia (1997/98), Russia (1998), Brazil (1998/99), Turkey (2001) and Argentina (2001/02) the most notable.
The prolonged weakness in emerging market equities was only one symptom of the turmoil – it took 11 years to regain the 1994 highs in US dollar terms.
But these crises set the conditions for the boom which was to follow. Extremely depressed exchange rates (which became a policy goal via persistent central bank currency intervention) and higher savings rates provided the basis for current account surpluses. Macroeconomic policy became more orthodox: governments tightened their belts and inflation targeting caught on, as in developed countries. Macroeconomic resilience was achieved.
As globalisation accelerated, China’s enormous economic success and its sheer scale fuelled a commodity supercycle, benefiting producers in the emerging world. The result was a golden era for emerging markets. Between 2001 and 2008, emerging economies grew at an average annual rate of 6.6 percent compared with 3.7 percent over the previous twenty years.
Extrapolation
The mistake of many analysts – and governments – was to extrapolate this success, rather than recognise it as a uniquely positive period for emerging countries. Some reversion to the mean was more likely; clearer still with hindsight.
Meanwhile, credit booms in several countries, most notably China, began to create their own vulnerabilities. As events have made clear, hubristic and complacent policy in good years left certain economies poorly equipped to sustain growth once the tide of rising commodity prices went out.
To a large degree, the problems in China are the consequence of the policy response to the 2008 global financial crisis. Faced with collapse in the US and Europe, Chinese policymakers dragged up the rest of the world with a stimulus programme, increasing domestic credit by more than 20 percentage points of GDP in 2009 alone.
Inevitably, the massive credit boom has come home to roost as the authorities try to deal with the fallout of bad loans in the infrastructure and property sectors, as well as corruption among party officials. And this has all occurred when China is ageing rapidly which will itself cause growth to slow more in the years to come.
Not the 1990s
The silver lining to the cloud overhead is that fixed exchange rates are mostly consigned to history. In years gone by, pressure on capital flows would sharply tighten monetary conditions, forcing a severe contraction and probably a banking crisis. Today, in most countries, the exchange rate takes most of the strain, lessening the impact on the real economy.
Moreover, despite some deterioration, macro imbalances are generally not as large as twenty years ago and inflation remains low in most countries. The latter point is important, as low inflation allows greater policy flexibility. A sufficiently large currency depreciation should create a boost to output via a rising trade balance, though the depreciation needed will depend on the extent of the collapse in a country’s export prices.
A challenging road ahead
As with much else, discussion of the outlook must start with China.
It seems inevitable that Chinese growth will slow substantially. The real question is whether it does so smoothly or in a chaotic way. While China still has room to catch up with the richest countries, it faces considerable headwinds: an unbalanced economic structure, a shrinking working-age population of workers and the challenge of institutional and political reform. China may continue to grow faster than many countries but its growth rate will be lower.
The fate of China and the developed world will determine the external environment facing other emerging countries. How each country fares will depend on the policies their governments choose.
* Tristan Hanson, is the head of asset allocation at Ashburton Investments.
** The views expressed here are not necessarily those of Independent Media.
BUSINESS REPORT