China and the coming economic Ice Age?
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After several years of riding high on foreign investment cash and commodity revenue, emerging markets are in for a shock.
The shift is already under way.
Net capital inflows in emerging markets stood at $3.9 trillion (R39 trillion at today’s exchange rate) between 2009 and 2012.
Between 2004 and 2012, net capital flows in emerging markets stood at a staggering $7 trillion, slightly less than half the size of the US economy.
The biggest concern today is that the quality of these investments has deteriorated. After all, the low-hanging fruit of the earlier years is gone, forcing investors to become more adventurous.
The other major development is that China, itself still an emerging economy, has become a major player in investing in emerging markets. It is estimated that as much as 30 percent of capital inflows in these markets in 2012 came from China and if it slowed down its investments now that would be a big blow to these markets.
China’s growing role has been based on several strategic calculations. Prominent among them was the need to guarantee that China’s appetite for commodities would be met. The best way to secure that is to own a stake in or lend to the commodity-producing companies abroad.
In contrast, US investors invested abroad in search of yield. They were responding to chronically low interest rates and several rounds of quantitative easing that flooded the US economy with liquidity, while domestic investment opportunities have been scarce for years now.
But these incentives may suddenly reverse. Even in a sluggish economic recovery in the US, ultra-loose monetary policy will come to an end.
The so-called tapering by the US Federal Reserve Bank – the ultimate termination of its programme of buying assets, such as mortgage-backed securities – will lead to an increase of market interest rates in the US. That will happen even if the policy rate – the Federal Funds Rate – remains unchanged. This changes the incentive for investors to take home their funds abroad, especially as the risk of their investments there has risen over time.
At the same time, China might not grow at a greater rate than 7 percent per year in the medium term, as it is facing multiple problems. These include challenges to its export-driven growth model, its exponentially greater economic base from which it must grow, sluggish global demand and falling competitiveness with the fastest-ageing population mankind has ever seen.
The common mantra that China must switch from an investment-driven growth model to a consumption-based growth model is easier said than done.
However, this necessary evolution also reduces China’s incentive to invest in emerging markets. China will be likely to soon start to deploy more of its financial resources at home.
As if this double blow of slower investments from the US and China were not bad enough, many of the affected emerging markets will also see the price of commodities – their major export products – slump. This is especially true for oil-exporters.
But the good news is that virtually all emerging markets have largely strengthened their international reserves to protect themselves against such shocks.
Yet, important as these buffers are, panicky investors can quickly lead to a rapid depletion of those reserves.
That is a particular danger if such behaviour is preceded or accompanied by capital flight (ie, domestic investors withdrawing their money and taking it abroad).
In looking forward to a world of much slower growth and a significant slowdown of capital flows into emerging markets, it is then important to assess which among them might be most affected. There are three major factors that must be considered. First, how dependent is the country on commodity exports, especially oil? Second, how large a role have capital inflows played in sustaining economic growth in the emerging market economy? And third, how dependent is an emerging market country on such inflows?
The latter two may seem measures of the same thing, but they are not.
A country may have a current account surplus and still benefit from large capital inflows leaving it with a strong balance-of-payments position. By the same token, it may have a very large current account deficit (also referred to as the savings/investment gap) and hence depend on foreign savings, meaning large capital inflows.
In assessing vulnerability to a combined “sudden stop” of capital inflows and a commodity price shock, the list is large for different reasons. Turkey, Romania, Morocco, South Africa and India stand out as being especially vulnerable. They have all run large current account deficits and hence depend on inflows. Brazil and much of Latin America are also at greater risk.
What lies ahead need not be catastrophic, but it will at a minimum require patience and deft policy management.
Uwe Bott is the chief economist of The Globalist Research Center.