Emerging Markets – Caught in the Crossfire

US monetary policy has missed its mark and it is a handful of emerging markets that look set to pay the price

The big guns of monetary policy used to combat sluggish economic growth are about to be put away but the real damage may be just about to kick in.  The Federal Reserve adopted loose monetary policy to get the US economy moving again but it is elsewhere where the effects have been felt the most.  Having benefited more from the loose monetary policy than the intended target, some emerging markets look set to suffer as a policy reversal prompts US investors to stage a destructive retreat back home.

Danger zone

The proverbial printing presses at central banks are like the heavy artillery of monetary policy.  Central banks such as the Federal Reserve had been pumping out cash to buy bonds as part of quantitative easing.  Yet, the US economy had failed to fire up with companies unwilling to invest while spending remains weak.  Investors with cash in hand turned their sights overseas and targeted emerging markets where economic growth was still perky. 

The surplus US dollars helped to lower interest rates for borrowers in many countries which had not gotten caught up in the global financial crisis.  The reduced borrowing costs pushed up lending elsewhere despite not having the same effects in the US economy.  The muted effects of monetary policy in the domestic economy prompted the Federal Reserve to unleash even more firepower.  Money, like some things, is fine in moderation but the bombardment of US dollars inadvertently created its own minefield. 

Borrowers in emerging market were only given access to cheap cash by borrowing in US dollars for a short period of time.  This was fine as long as the prospects for the US economy were poor and US dollars were readily available.  But any significant improvement in the US economy would see investors shift their money back.  A stronger US economy would also push up the value of the US dollar and make it tougher for overseas borrowers to pay off any debts in US dollars. 

Collateral damage

Like solider stationed in a hostile region, investors were set up to bail when the opportunity arose.  Just the mere mention by the Federal Reserve in May 2013 that quantitative easing might be coming to an end was enough to trigger a rush by investors to get their money out.  Six months of market volatility followed even though quantitative easing did not actually end until October 2014.  With the Federal Reserve now mulling lifting interest rates up from their low levels, more upheaval seems likely.

This is because money often does more damage on the way out compared to the gains when it is initially welcomed.  Yet, the lure of cheap cash is too much to ignore.  Even the financial sectors in richer countries have shown themselves to be unable to cope when too much money is on offer.  Less developed banking systems in emerging markets are often even worse at putting any cash to good use.  This increases the likelihood that many borrowers will struggle when US dollars are harder to come by. 

As the aftermath of the global financial crisis has made painfully clear, a swift end to a lending boom is not something easy to get over.  In its attempts to deal with an US economy sagging under the weight of excess debt, the Federal Reserve has inflicted the same woes on others who are less able to deal with the consequences.  Like any form of warfare, it is the innocent victims that suffer the most.

Growth in China: Steel vs Butter

Diverging fortunes of countries down under illustrate how China is changing

Trading with China can be like a roller coaster ride – lots of ups and downs without knowing what is coming next.  At a time when most of the global economy has been in the doldrums, tapping into the Chinese market has lifted the economies of a lucky few.  Australia and New Zealand are among the fortunate ones, but the diverging fortunes of these two countries highlight a shift in China’s development which will have profound effects for many others.

Riding out the twists and turns

Economic development of any country is never a smooth ride.  Growth in China has been bumpier than most with its economy jumping into life at a time when the world was becoming a much smaller place due to globalization.  The Chinese economy has expanded at an unprecedented pace due to its role as a manufacturing base built on access to foreign markets and funds from overseas. This has resulted in greater scarcity of many of the basic commodities extracted from or grown in the ground.

Countries fortunate enough to possess an abundance of natural resources, such as many in South America and Africa, gained a boost from high commodity prices at a time when the global economy is weak.  But these benefits are likely to be a temporary upturn with demand for commodities shifting as China develops.  The initial stages of the growth in China came through investment amid a building frenzy as firms rushed to put up factories to produce goods for exporting.  This has continued as the Chinese government has ramped up spending on infrastructure to counteract the weak global economy. 

The result has been a prolonged period of China sucking in resources such as iron ore, coal, and natural gas.  However, spending on investment was surging ahead at a pace which could not continue and has shown signs of an inevitable tailing off over the past year or so.  The government has instead eyed consumption as a new source of economic growth and as a means to keep the population happy.  This change in focus in China will be felt throughout the global economy.

Good and bad of changes in China

China was at the forefront of the mind of Your Neighbourhood Economist during a recent visit back home to New Zealand and a side trip to Australia.  Demand from China helped both countries to avoid a downward spiral following the global financial crisis, with Australia racking up an astounding 22 years without a recession.  Yet, it is Australia that is looking nervously at developments in China while New Zealand is looking to raise interest rates due to a booming export industry. 

The reason for concern among Australians is that its mining boom is starting to peter out.  Exports to China are still hitting record highs even as growth in the Chinese economy slows.  But investment in the mining industry has dropped off as commodity prices have fallen.  This leaves Australia in a tricky position as money from mining has pushed up the cost of living, resulting in wages that are too high to be competitive.  Employment may be starting to suffer - Your Neighbourhood Economist struggled to spot many Australians among the cabin crew on the Qantas flights to and from London.

Two gauges of economic health augur tougher times ahead.  The central bank in Australia has pledged to keep interest rates at a record low of 2.5% for some time.  Along with this, the exchange rate for one Australian dollar has dropped below parity with the US dollar after having been worth more than its US counterpart in 2011 and 2012.  In contrast, New Zealand has seen its dollar continue to climb in value with the NZ central bank already having lifted interest rates twice to 3.0% in 2014.  It is milk and cheese that is driving the upturn in the New Zealand economy with the Chinese developing a taste for dairy products as their levels of wealth expand.

The shifting fortunes of Australia show that tapping into a growing Chinese economy has its downs as well as ups.  Despite this, New Zealand shows how change in China can be turned into a positive.  With China as one of the few bright spots in the global economy, this is a story that a lot of countries will be interested in.

The True Cost of Quantitative Easing

Quantitative easing has been short-term pain relief with long-term damage and some ugly side-effects

Life on drugs must be great – but the high cannot last for ever.  Such has been the case with quantitative easing.  The financial markets have been buzzing due to the money pouring out of the Federal Reserve as part of its monetary stimulus program.  The costs of shot after shot of extra cash are easy to forget when times are good.  It is only now that the Federal Reserve has decided that it is time to wean investors off their quantitative easing fix that we are seeing the true repercussions of addiction to easy money.

Costs of kicking the habit

Investors are already getting the shakes as the Federal Reserve moves to lower the dosage of its monetary policy.  Stock markets around the world wobbled in early 2014 as the Federal Reserve trimmed US$10 billion off its monthly bond purchases in December and January.  The extent to which stock markets have benefitted from the monetary stimulus is unclear but substantial.  This means that volatility is likely to continue as share prices find their appropriate level without any interference from the Federal Reserve.

Investors have reacted strongly to any attempts by the Federal Reserve to renounce its role as drug dealer for the financial markets.  The policy of quantitative easing in itself has been like a drug habit – easy to start but tough to break.  As is often the case with bad habits, it is only when trying to quit that the real costs become apparent.

It looks as if the comedown will take the form of a lethargic economic recovery that may last for years.  Uncertainty is one of the primary stumbling blocks standing in the way of economic rehabilitation.  The slow tapering of quantitative easing followed by interest rates being gradually pushed upward will be enough to keep even the experts on edge.  Thus, while the monetary stimulus has eased the pain of the global slowdown, the economy will be held back by the “ifs” and “buts” of monetary policy.

Emerging Markets Hit by Side-Effects

If the past few weeks of stock market jitters are anything to go by, it may be emerging markets that suffer the worst withdrawal symptoms.  Many developing countries had benefited from the extra cash in the global financial system coming from quantitative easing.  Low levels of domestic savings mean that such countries rely on funds from overseas and their chronic cravings for growth make poorer countries prone to overdosing.  Their vulnerable position leaves them at the mercy of the money peddlers from wealthy countries who often have the upper hand.

It is a sad twist of fate that the worst consequences of monetary policy in the US will be felt far from its shores.  One of the reasons why quantitative easing has had little effect in boosting the US economy may be due to a considerable portion of the newly printed money heading overseas.  The amount of cash flowing out of the US has been large enough to warp the economies of some developing countries.  The hit on their financial wellbeing as the money returns back to the US has also been a downer.

A silver lining is that past crises have taught emerging markets to be more resilient – this time at least the IMF will not be kicking down any doors (like the police at a narcotics bust) as might have been the case in the past.  It is also clear that emerging markets still need to do more to better manage their addiction to foreign funds.  While emerging markets have learnt some lessons from past predicaments, we can only hope that the Federal Reserve can do the same. 

Fragile Five – the Silver Lining

A deeper look into the problems of the Fragile Five shows that the fault does not lie with global finance.

There are times in life when it is tough to figure out who is the hero and who is the villain.  Such may be the case with the current turmoil engulfing emerging markets.  Adding ignominy to injury, economists have tarred Brazil, Turkey, India, Indonesia, and South Africa with the dubious epithet of “the Fragile Five” as an outflow of funds has sparked a multitude of economic imbalances.  Investors have been quick to yank their money out as higher investment returns are expected to follow the paring back of monetary stimulus.  First impressions might suggest that the blame lies with the fickle nature of global finance. 

Yet, as with all good detective novels, it is not always the obvious culprit who is in the wrong.  It is entirely logical that money should move out of badly run countries in the same way as shoddy companies are shunned by investors.  It is more often corrosive politics that are to blame for driving investors away.  With this in mind, a shake-up at the (invisible) hands of the financial markets may work out for the best.

The blame game

Politicians themselves have been quick to blame the Federal Reserve in the US.  The Federal Reserve was buying US$85 billion in bonds each month in 2013, which drove down the yields on US bonds and prompted investors to shift their money overseas in search of better returns.  Reductions in these monthly bond purchases have triggered a return of funds from overseas which has caught out many emerging economies.

If politicians in emerging markets were honest (admittedly, an odd concept), their fingers would be pointing closer to home.  Many emerging economies benefited from the cheap capital but came to rely on it too much.  Economic growth which had been sustained past the global financial crisis began to slow as governments put off reforms to keep their economies going.  Instead, governments tapped into funds from overseas to ramp up spending and cover growing shortfalls in demand.  This only masked the problems which have since been laid bare by the countries being stripped of their external financing (see No need to fear for the Fragile Five for more on this). 

No more excuses for politicians

All of the talk surrounding the Fragile Five tends to focus on their economies but the real issue is with their politics.  The rise of the middle classes in these countries has been a catalyst for more responsive government.  Minor issues have triggered large protests fuelled by frustrated voters.  A rise in transport costs incited upheaval in Brazil.  A sit-in protest at a park in Istanbul escalated into unrest throughout Turkey.  The rapid rise of an anti-corruption party threatens to derail the major parties in elections in India.  Workers strike in South Africa demanding higher wages.

The faltering economic growth has revealed the inadequacies of government.  Slower economic growth means that voters cannot be bought off with higher incomes.  Their dissatisfaction has now been coupled with that of investors who hold the upper hand in terms of where they stash their cash.  Being spurned by investors does involve some short-term pain.  However, this can be limited by countries building up foreign currency reserves.  Other measures such as controls over inflows and outflows of funds are increasingly gaining acceptance (for more, see beware of a flood of funds).

There are clear long-term benefits from keeping politicians in emerging markets honest by means of checks rooted in global finance.  Voters everywhere are disillusioned with their politicians (a sentiment shared by Your Neighbourhood Economist) and emerging countries are no exception.  But levels of wealth in poorer countries are considerably more dependent on the quality of their politicians.  Governments in developing countries also have a tendency to fiddle with the economy through state-owned firms or measures against free trade.  Argentina is probably the best example of this - the country is so badly run that it does not even attract enough foreign capital to merit inclusion in the Fragile Five.

Extra incentives for governments to adopt appropriate policies should thus be welcomed.  Trying to stick to the economic equivalent of a diet may not be easy but there are rewards at the end of it.  In conclusion, there is no point in blaming someone who keeps you on the straight and narrow, in fact, there is a lot to gain.

No need to fear for the Fragile Five

While it may look like emerging markets are being tormented by global investors, there could be a happy ending.

What's in a name?  Well, the moniker “Fragile Five” suggests all is not rosy but the countries (Brazil, Turkey, India, Indonesia, and South Africa) labelled thus have things other than name calling to worry about.  Namely, the fact that it appears as though the Fragile Five are being picked on by the international financial system.  The leader of the pack has been the Federal Reserve whose trimming back of its stimulus package has triggered a massive shift in global finances.  While no country would choose to be browbeaten by investors, a lecture on bad economic policy might help these countries avoid a story of more woe in the future.

What is going wrong?

Emerging markets have fallen victim to the fleeting nature of foreign investors.  The global financial system has been awash with money due to central banks such as the Federal Reserve printing cash to stimulate Western economies.  Low financial returns in developed countries have prompted investors to look abroad for places to park their money.  Perkier economic growth in developing economies has been an oasis for investment as options elsewhere dried up.

Emerging markets are typically in need of extra cash.  There are little savings available to fund the investments needed to build homes, roads, and factories as the economy develops.  These cash-starved countries are a good fit with cash-rich investors but there is a need to get the balance right.  Unfortunately, many emerging economies come to overly depend on the cash provided by investors to fund their economic growth.  As is the case with things offered up on the cheap, the good times don’t always last and investors always have the option of taking their money elsewhere.

Along with slumping stock markets, the effects of emerging markets falling out of favour with investors are most keenly felt through a drop in currencies in emerging markets.  A weaker currency results in emerging markets having to pay more for their imports, which exacerbates the problem of high spending on overseas goods such as oil.  Higher prices for imports also push up inflation which is already too high in many emerging markets.  Many of these countries also struggle with large government budget deficits as slower economic growth prompts greater fiscal spending.

How things are being put right

While the Federal Reserve has been measured in its approach to changing policy, central banks in the Fragile Five have been all action.  The central bank in Turkey lifted its overnight lending rate for banks from 7.75% to 12% while their counterparts in other countries also increased their rates by smaller amounts.  The higher interest rates are designed to make it more attractive to hold the currency of that country as part of an attempt to stem the selling on the foreign exchange markets.  An increase in the costs of borrowing also has the effect of cooling the economy and reducing the demand for imports.

It is lucky for the Fragile Five that the most important actions have already been taken to prepare them for the ebb and flow of global capital.  Emerging economies have learnt from the Asian financial crisis in 1997 when many economies in Southeast Asia were decimated due to high levels of foreign debt and a system of fixed exchange rates.  The adoption of floating exchange rates along with large foreign currency reserves means that another crisis is unlikely.  Inflows of foreign funds are treated with less welcoming arms and greater acceptance of the need for controls over the movement of money in and out of economies with less developed financial systems (for more info, see beware of a flood of funds).

Your Neighbourhood Economist would even argue that there are some positives.  The global financial crisis and the Eurozone crisis have shown what can happen when imbalances in an economy get out of hand.  Investors can be a fickle bunch (many people are where money is concerned) but investor sentiment is typically a good gauge of how well an economy is operating.  If subprime mortgages or lending in southern Europe had also led to a revolt in the market, most of us would be better off (see bond investors ain’t all bad for more on this).  With this in mind, perhaps foreign investors should not be seen as bullies, but more like an older brother (who may not always be nice) keeping you out of trouble.

Insights from Asia: More infrastructure for everyone

Infrastructure is like eating vegetables – more is always better (with one exception) 

Infrastructure was on the mind of Your Neighbourhood Economist during a recent trip around Asia.  Roads
in Cambodia were so bumpy that it was often difficult to think about anything else.  Investing in infrastructure is a no brainer for developing countries – it helps the economy run more smoothly by lowering the costs of doing business as well as helping to create jobs.  The same logic also applies to richer countries although it is tougher to decide where to spend any available funds.

Infrastructure – what is it and why is it good?

Infrastructure is easy to spot but hard to define.  Essentially, it is the facilities that are necessary for an economy to function.  Companies need electricity to power their factories and offices, roads to be able to move goods around, and phones and the Internet to communicate with others.  The concept of infrastructure could also be stretched to include the courts and laws which govern business, hospitals to heal sick workers, schools to produce the necessary skills in the workforce, and police to reduce the effects of crime.  However, let’s stick to the basic definition to keep things simple.

A lack of proper infrastructure can get in the way of doing business.  Clogged up roads or an intermittent power supply will create delays which put operations behind schedule.  The extra costs of power generators or the time taken in transporting goods will eat into profits.  A patchy phone or Internet network will hamper access to information needed for key decisions.

Shortfalls in infrastructure are more obvious in developing countries as by definition major parts are still being built.  Construction typically struggles to keep up with rapid growth in economic activity.  The large number of new cars on the road in Phnom Penh was a surprise but the amount of work being done on the roads was not.

In order to generate higher levels of wealth (which will typically mean more new cars), a developing economy needs people to move from working on the land to engaging in more economically productive activities in the cities.  Insufficient infrastructure is an obstacle that can inhibit economic expansion and trap a country at a lower level of income.

Tough decisions lead to neglect of infrastructure

The potential benefits from infrastructure also extend to richer countries.  More developed economies typically already have considerable infrastructure but this requires maintenance as well as extra spending due to shifting economic conditions.   It is far trickier for governments in developed countries to figure out what new infrastructure is worthwhile.  That spending on faster internet connectivity will be beneficial is a given, but it may be less obvious where to allocate the budget for, say, transport infrastructure.

Whether to invest in more roads, better railways, or bigger airports depends on predicting the lifestyles people will adopt in the future.  Ideally, the private sector would take on this burden but the copious amounts of cash along with the risks involved in major construction projects and the long-term scale of such operations are too much for businesses to handle.  Consequently, it is left to governments to determine the best courses of action.

This often results in tough infrastructure decisions being kicked down the road. Despite large budget deficits, the case for ending the neglect of infrastructure seems stronger than ever (following this link for the exception) due to high unemployment and the fact there are few engines of economic growth.  Just like your mother would tell you to eat your veggies, more infrastructure would be good for our economic health.

A New Inconvenient Truth

The reality which faces the West that politicians dare not speak of

The rise of countries such as China, India, and Brazil will be a tectonic shift in economic power but it is also a change that is long overdue.  The relative dominance of Europe and the United States in the global economy is a historical accident brought about by the early formation of capitalist economies in these parts of the world.  The response to these new challengers will define the role that the United States and Europe play on the global stage in the future and the initial signs do not look good. 

The Western world spearheaded by Europe and the United States have generated the bulk of the wealth in the global economy for most of the past century.  As early ago as 1990, the United States accounted for around 23% of global GDP and the countries which now constitute the European Union accounted for roughly 32% while respectively only making up 5% and 9% of the world’s population.  Yet, growth in the countries such as those grouped together under the label of BRICs (Brazil, Russia, India, and China) is the beginning of the end to this distortion in the distribution of global wealth.  The BRICs countries, who accounted for just 8% of global GDP despite making up 43% of the number of people worldwide in 1990, have seen their share of global GDP increase to 18% as of 2010.  The figures for the United States and the European Union have dropped back respectively to 23% and 26% in 2010 and this is a trend that will continue for decades into the future.

It is not that the economies in the United States and Europe have not been expanding in size but growth is not as easy to generate as elsewhere.  Loading up on debt helped to create a booming economy for a while but excessive lending eventually brought about a deep economic slump (for more info, refer to Tale of Two Recessions).  The global financial crisis has instead allowed other countries to catch up faster and to lay siege to the position of the United States and Europe at the top of the global pecking order.  The concentration of wealth in these Western countries has allowed them easy access to resources such as agricultural produce and mineral deposits from around the global as well as ready markets for their manufacturing goods.  But industrialization in countries which were previously just mainly sources of raw materials for the United States and Europe has given rise to competition – both in terms of other countries snapping up resources and of creating rivals to Western firms.  Economic power has also allowed Europe and the United States to shape global institutions to their liking. 

But this imbalance of wealth was never destined to last.  The gap between the rich and poor became too great and plummeting transport costs meant that goods could be manufactured anywhere.  The changes stemming from this will shape the world for generations to come and in ways which cannot yet be grasped.  Rather than bracing themselves to face the reality of this new challenge, both Europe and the United States have been embroiled in domestic issues as politicians struggle to deal with growing levels of debt. 

Economic theory espouses the benefits of free trade and an open economy where countries should specialise in what they are good at.  For the United States and Europe, this would be high-tech or high-value-added sectors such as product design, computer software, and precision manufacturing which make use of their skilled workers.  Yet, Western governments have shot themselves in the foot through mismanagement of their finances.  The resulting masses of public debt have restricted the ability of governments to invest in, for example, education which has suffered in many richer countries as governments focused more on cutting taxes.

Politicians in the United States and Europe need to be more honest with voters.  It is easy to convince voters that the good times will return and to try and hold off the inevitable.  But this will merely delay the day of reckoning and will make it so much worse than it needs to be when it does come around.  Many current policies, such as reducing immigration even for skilled overseas workers, run completely against what needs to be done and suggest that politicians either do not grasp the changes already underway or prefer to pander to the preferences of a public who is adverse to change rather than confront them with reality.  Sooner or later, this inconvenient truth will become apparent, but by then, it may be too late.