Since mid-May emerging countries’ situation has changed dramatically. Large capital outflows and currency depreciation have weakened a lot of them. In the second half of August the focus was on India, Brazil, Turkey or Indonesia. These countries but also many others have experienced a slowdown in growth for several months now and capital outflows recently. It is the combination of these two factors that weakens them.
This situation leads to an impossible trade-off for economic policy. Being tough on monetary policy to avoid currency depreciation implies a supplementary risk on growth. But being too lax to be supportive for growth could lead to depreciation and then to imported inflation. Countries like Brazil and Turkey where inflation rates were high in the past (and sometimes very high for Brazil (2948% in 1990 according to the IMF)) have chosen a strong monetary policy in order to avoid the risk of higher inflation (higher central bank interest rates). For other countries the choice has been to take temporary measures in order to reduce capital outflows (India), to put extra taxes on imported luxury goods (Indonesia) or to sell foreign reserves to limit currency depreciation (Brazil has a USD 60bn plan until the end of the year). These kinds of measures can be efficient in the short run. In other words if the crisis is temporary they can help, if the crisis is longer or deeper because of internal imbalances then it is just way to gain times but not to resolve the issue.
Countries mentioned above and others have also a large current account deficit (see chart below). This is important for the two following reasons:
1 – Their current account deterioration came from strong inflows of short-term capital. As inflows were substantial those countries had a simpler way to finance their growth. Current account deficit reflects a lack of saving. Capital inflows then helped to finance the imbalance reducing the lack of saving. In other words current account imbalances were financed by short-term capital inflows.
Usually in this situation inflows can help to develop some new activities but sometime be the source of speculation. This can be the case on real estate. A recent paper on India (see here) shows that these flows have led to overvaluation in real estate.
2 – The question then is to know the influence of this short-term flows and its counterpart in terms of productivity gains. An investment done in industry can lead to productivity gains giving the capacity to a more autonomous growth in the future. At the end this can help to reduce the current account imbalance. An investment done in real estate, as it is usually the case, implies low productivity gains that will not reduce the current account imbalance. It will probably enlarge it as a lot of resources will be used to trigger and then to finance a bubble.
Then when there is a capital outflow episode, countries with large current account and bubble are fragile and are in a very tough situation to resist.
Countries with large current account deficit are in a very weak position as they have no immediate solutions to finance it. Short term capital flows are no longer available. Measures can be taken and be efficient if the crisis is temporary. If it is longer structural reforms are needed to give more autonomy to the growth process and solution in the long-term to rebalance the current account. But, this can have a high political price in the short run and that’s probably why governments will try to be solved the crisis with short-term measures. But the probably of failure is important and we cannot exclude that in the coming months some countries will ask the IMF for help.
In other words, short term capital inflows have relaxed the target to a more autonomous development. This liquidity was ample and has changed the resources allocation leading sometimes to bubbles (in real estate). Imports were high and resources that were devoted to exports were redirected to the internal market and used to develop activities that do not imply productivity gains. This can work as long as capital inflows are important and finance the current account. But when capital flows change direction then there is a problem to finance the current account. The question then is to know how to reduce the imbalance? This will be the main question in the coming weeks. Measures that were presented in the introduction are not structural, just the expectation that they will be sufficient and that the crisis will remain short. If the crisis is longer, the IMF could come and help.
The adjustment process that will be seen in emerging countries can be a chance for the USA and for Europe. During the last decade the balance of strength has been in favor of the emerging. This can be reversed. In a certain way that’s what Bernanke said in his press conference on June 19. He was confident that the improvement of the US economy could lead to a renewed leadership. This means that I am not sure that the strategy that will be used by developed countries will a cooperative one. Beyond the economic issues there are always political questions and an opportunity could be seen for the USA, and may be for Europe, to regain a political leadership
To understand the current situation in many emerging countries, three factors have to be mentioned.
1 – Europe and the United States are generally major clients in many emerging countries. But since 2011 Europe is in recession and the U.S. economy is experiencing lower growth trend than what was observed in the past. Demand that Europeans and Americans could address to emerging countries remained low throughout this period. Emerging countries even if they have developed a more robust domestic market in recent years with the emergence of a larger middle class do not have the ability to be autonomous in their growth process. They still need an impulse and a support from the industrialized countries.
2 – China does not play the same role than in a recent past. Spearheading of emerging countries in the 2000’s, China has been the source of very strong positive impulses for most of them. Since its accession to the World Trade Organization in late 2001 China has done everything to become a business partner for most emerging countries. China is now the main trading partner for most of Asian countries, for country like Brazil and some others in Africa. In fact China has improved the south-south trade. A lot of emerging countries became dependent on Chinese impulse.
But things have changed. China two years ago shifted its mode of growth, reducing its impact on emerging countries. This is a long-term change and we cannot imagine that the aggressive partnership China wanted to build could come back. In a very simple measure, Chinese growth rate was 10 % on average for the last 20 years with peak at 14%. Now the growth range is close to 6-8%. The impulse will be different.
Emerging countries have to build new strategies that will not depend too much on China. This will be complicated for raw materials exporting countries like Brazil and South Africa where China was and is still a major customer.
In other words, a large number of emerging countries have lost the impulse that came from outside. They will have to develop a more autonomous way to grow, less dependent on external impetus. This can take time.
3 – The third issue is the change in the US monetary policy. On May 22 Ben Bernanke, the Federal Reserve president, was in the US congress for a testimony. At the end during the Q&A it appeared that the Fed will change its monetary policy stance in the coming months. This was confirmed on June 19 during a press conference after a monthly meeting on monetary policy. During the press conference Ben Bernanke said that he was more confident in the US economy to recover and that this could lead at the end to an exit from the current very accommodative monetary policy.
This is the source of capital outflows in emerging countries. We usually notice that when monetary policy is becoming more accommodative then capital flows go from the US to the rest of the world and mainly to emerging countries. When the Fed is more confident in the economy, when downside risks are lower and capital flows are back to the US. This usual behaviour has been at work since mid-May. We can see that on the chart below. This has weakened emerging currencies. On the chart below we see the break following Bernanke’s testimony.
What can be expected ?
Now the situation is very complex for emerging countries. They have to renew their growth process to become more autonomous and in the short run they have to find a way to finance their current account imbalance.
We cannot expect that China will change its mind rapidly, we see that Europe has difficulties to exit from its deep recession and that the US economy will not jump above its historical trend of 2.5 – 3% GDP growth.
Their future is very dependent on what they will do because no strong and long-lasting external impulse can be expected. This means that it will be very difficult to reduce their current account imbalances except if they develop rapidly their industry to improve their productivity or if they accept to reduce rapidly their standard of living. After the immediate and temporary measures explained in the introduction, this latter is the most probable but it will have a political cost.
One solution which could be the right thing to do will be to acceleration cooperation between countries of the same region. This kind of union is usually very fruitful and could reduce the cost of the adjustment.
The other issue is the uncertainty on US monetary policy. Bernanke has presented guidance that will condition interest rate change to a level of the unemployment rate. This threshold is 6.5%, this is the level at which the Fed could start thinking of changing its interest rate. The question is to know if this guidance will be respected by the Fed, and more specifically will this guidance constrain the new Fed president. Barack Obama will choose the future president this fall and this latter will have to be confirmed by the Congress. This will take time and if the future president is Larry Summers then probably the guidance will change. That still lead to uncertainty but we cannot expect a reversal of capital flows.
In conclusion we can’t find common trends that will drive emerging countries as it was the case since the beginning of the 2000’s. There will be more diverse strategies of development and countries could gather to create and enforce regional unions. Emerging countries will probably look like mosaic more than in the recent past.
Chart 2 – Indian rupee versus US Dollar
I have chosen the Indian Rupee to show the break in mid-May in the currency trajectory. Other currencies like Brazilian Real or South African Rand to name a few have also depreciated deeply.