When rebalancing is not good news
Before the global financial crisis, it was typically argued that the world economy needed to “rebalance” to guarantee lasting economic health.
Developed economies had excessive current account deficits while emerging economies had excessive surpluses. If only these imbalances could be reduced, the world economy would be a much happier place. It turns out that this was too optimistic a view: imbalances have narrowed but it has been a “recessionary” rebalancing, associated with dwindling demand for emerging market exports, undesirable monetary policy contagion and, in some cases, a structural worsening of competitiveness.
For a while, the promise of cheap dollars – courtesy of the Federal Reserve’s printing press – masked an underlying deterioration in economic performance in the emerging world: too much hot money and too little productive investment. The global hunt for yield encouraged huge capital inflows into emerging nations, even as their economies began to slow and their labour costs rose.
For anyone who has spent time examining the eurozone crisis, this story might sound eerily familiar. Cheap euros from northern Europe poured into southern Europe triggering domestic demand booms even as structural economic performance worsened. The resulting current account deficits could be funded for a while but, with an increase in risk aversion following the onset of the global financial crisis, the deficits ultimately proved unsustainable.
The long-term emerging market story remains positive, supported by a series of encouraging supply side factors. In the short term, however, current account deficits will remain in the spotlight. With little improvement so far, the risks of currency weakness, higher interest rates and more in the way of disappointing growth, remain uncomfortably high.
Leaving the emerging markets behind
While developed economies appear to be enjoying a new lease of life, the emerging economies are in a spot of bother. Recent indicators point to welcome reacceleration in economic activity through much of the Western world: in August, the US manufacturing ISM survey rose to 55.7, the highest reading since June 2011, while the UK services Purchasing Managers’ Index (PMI) jumped in July to 60.2, pointing to a return to the buoyant conditions seen before the onset of the financial crisis (charts 1 and 2).
Within the eurozone, both France and Italy posted better-than- expected Q2 GDP numbers, prompting claims that the eurozone recession was now over. Meanwhile, measures of consumer confidence have mostly strengthened in recent months (charts 3 to 5).
The same cannot be said of the emerging world. HSBC’s own Emerging Markets Index – a composite PMI for 16 emerging nations – has fallen away this year suggesting, at the very least, a period of unusually weak economic growth. Across the emerging world, the various PMIs remain mostly soft, even as readings in the West are resurgent (charts 7 to 8). Measures of consumer confidence are mostly depressed. Meanwhile, currencies have come under sustained pressure, forcing some central banks to raise interest rates even in the light of sustained economic weakness.
What is going on?
PMIs not the full picture
In themselves, the PMIs say little about whether the West is on the verge of returning to pre-crisis growth rates. The manufacturing PMIs, for example, may have risen from rather anaemic levels seen through much of last year but none of the readings is, as yet, back to 2010 levels. As it turned out, the optimistic readings that year turned out to be no more than a false dawn.
There is no guarantee that this time will be any different. The PMIs ask companies whether things are better or worse than last month: should a large number of companies say that things have gone from “terrible” to simply “bad”, a high PMI score will be recorded even if, in the event, there is no real recovery in sight.
Nevertheless, it is odd that the economic signals in the developed world are improving – in some cases, like the UK, triggering upward revisions to our growth forecasts – while those in the emerging world are worsening. Is this the beginning of some kind of decoupling?
If so, why?
The China syndrome
One possible reason is the impact of China’s economic slowdown on incomes elsewhere in the world.
China’s scintillating growth in recent decades has been particularly commodity intensive. This led to a sustained increase in commodity prices which, in turn, supported terms of trade improvements for the world’s major commodity producers (and, of course, worsening terms of trade for Western commodity importers). For much of the emerging world, the China boom led to windfall economic gains without any real need for structural reform. Now that China is slowing down – and Beijing is seemingly content on focusing on the “quality” rather than the “quantity” of growth – the rest of the emerging world is suddenly a lot more exposed.
This explanation, however, only goes so far. China’s economic slowdown is primarily a consequence of weaker export growth, not a sudden loss of domestic demand (indeed, it was only thanks to a domestic demand splurge that China was able to carry on growing so rapidly in the immediate aftermath of 2009’s global economic meltdown).
In the years before the onset of the financial crisis, exports were rising at an annual rate of 20-30 per cent. Since the onset of the crisis, the pace of expansion has dropped to an average of five to10 per cent. Not surprisingly, China’s current account surplus has rapidly dwindled, dropping from $371 billion in 2007 to $193 billion in 2012.
Recessionary rebalancing
On the face of it, this reduction in China’s current account surplus might be regarded as good news, suggesting not only a rebalancing of China’s own economy away from exports towards domestic demand, but also a rebalancing of the global economy: a smaller Chinese surplus entails either smaller deficits or larger surpluses elsewhere. This is, after all, what many policymakers wanted to see. It turns out, however, that the story is not quite so encouraging after all.
Table 14 shows the biggest shifts in current account positions relative to a country’s own GDP over the past five years alongside growth rates of both exports and imports and shifts in investment income from abroad. The numbers are revealing. Those countries experiencing the biggest “improvements” in their current account positions achieved these results not so much because export growth accelerated but, instead, because import growth decelerated. Consistent with this, those countries which saw the biggest “deterioration” in their current account positions did so not because import growth accelerated but, instead, because export growth slowed down dramatically.
In effect, we have witnessed a “recessionary rebalancing”. This “recessionary rebalancing” was sustained largely thanks to the combined effects of Western deleveraging and quantitative easing. Countries going through deleveraging saw unusually weak domestic demand, thereby limiting import growth.
Their central banks responded by cutting interest rates and indulging in various forms of quantitative easing.
This, however, only served to reignite the hunt for yield which, pre-financial crisis, had contributed to the boom in mortgage-backed securities and other “toxic” assets. In the post-financial crisis world, however, the hunt for yield went elsewhere: into equities, corporate bonds and, most obviously, into the emerging world.
These reignited flows created a series of “gaps” between economic reality and financial hope: US equities rose rapidly even as the US economy stagnated, government bond yields dropped dramatically even as fiscal positions became more precarious and emerging nations struggled to tame excessive capital inflows as investors took advantage of the higher interest rates on offer. Inevitably, their balance of payments positions deteriorated: rapid inflows led to lower interest rates, higher currency values and elevated domestic demand.
Structural weaknesses
Unfortunately, these policy stimulus effects only masked underlying structural weaknesses. Brazil’s rapid rebound from the financial crisis became unhinged last year thanks in part to an earlier over-valued exchange rate, an excessive reliance on credit-fuelled consumption, a lack of educated workers and, in more recent years, an excessive increase in wages relative to gains in productivity. India’s position is not dissimilar, even if its supply-side problems relate more to a lack of infrastructure investment, particularly in areas like power generation.
A combination of generous capital inflows, lower interest rates, rising wage costs, deteriorating competitiveness and deteriorating balance of payments is not exactly unique. It is, after all, precisely the set of conditions experienced by countries in southern Europe before the onset of the financial crisis.
Admittedly, balance of payments positions for southern European countries back then were far worse than those in the emerging world today but, directionally, the stories are broadly consistent: indeed, the pace of deterioration for emerging markets has been, on average, greater even if the starting point was – in all cases – a lot better.
For both the southern European countries and, more recently, the emerging world, initial huge capital inflows in pursuit of higher yields masked underlying structural weaknesses which only got worse as the capital continued to pour in. Of course, the response will differ – southern European countries had to put up with painful austerity whereas emerging nations may, instead, allow their exchange rates to take the strain. Either way, however, an adjustment is required (for the emerging market vulnerabilities).
The picture becomes clearer
It now becomes a little easier to explain why, since the beginning of the year, the evidence has increasingly pointed to a modest recovery in the Western world while, at the same time, the emerging nations are suffering a significant degree of discomfort.
• China’s economic slowdown – a reflection of the new Quality Not Quantity approach – is a bigger threat for the emerging world than for the developed world, a reflection of the skewed sensitivity of commodity markets to Chinese growth.
• The adjustment might have been painful but the countries of southern Europe are no longer so dependent on capital inflows: Italy, Spain and Portugal are likely to have modest current account surpluses while the Greek current account deficit has collapsed. If there is a sudden drop in global capital flows, the vulnerabilities exist elsewhere.
• The “whatever it takes” commitment by Mario Draghi, the European Central Bank president, to keep the euro together in effect removed near-term currency risk in the periphery. Although there has been no return to pre-financial crisis “business as usual”, yield spreads have narrowed. Currency risk within the emerging world, however, has not gone away.
• The Federal Reserve’s tapering plans suggest that any country running a large current account deficit will find funding increasingly difficult to come by. Many emerging nations find themselves in this boat.
• In some cases, the emerging nations have not really helped themselves. Thanks to the luxury of cheap capital inflows, they were able to deliver near-term increases in demand with little focus on supply dynamics. The result, in some cases, has been a worsening balance of payments position linked with slower growth, rising wage costs, lost competitiveness and, more recently, higher interest rates.
• Because Europe is safer than it once was, because the US is now thinking about taking its foot off the monetary accelerator – even if it is a long way from applying the brakes – and because structural problems within the emerging world have become more visible, any change in global liquidity conditions is far more likely to have a negative effect on the emerging world than the developed world: this, in combination with China’s slowdown, may account for the peculiar “decoupling” that has taken place this year.
• For some emerging markets, the combination of much slower growth with still-large current account deficits suggests that the painful adjustment phase is not yet over.
Does this mean that the emerging market story is now at an end? Not at all. Emerging countries have had to cope with far worse pressures than we’re witnessing today: think back, for example, to the Mexican crisis in 1994 or the Asian crisis in 1997, when economies collapsed and some argued that the “miracle” was over. Back then, current account deficits were, in many cases, far bigger than they are today.
Nevertheless, after a year or two of significant economic hardship, emerging nations were able to rebound strongly. With illiquid capital markets, emerging nations remain vulnerable to sudden reversals of international financial flows.
That, however, doesn’t alter the fact that they have tremendous long-term supply-side potential. Urbanisation, improved education, the development of the “Southern Silk Road all these things point to further rapid increases in living standards in the years ahead even if, in the near-term, emerging nations find themselves in a bit of a funk.
Stephen King is chief economist, HSBC Bank plc.