Are emerging markets losing their brand appeal? Global Economic Outlook, Q1 2014
Many emerging markets faced financial volatility in the wake of the US Federal Reserve’s discussion about tapering. Countries with poor fundamentals and weak policies have been hardest hit during this period of uncertainty, and sustaining growth will require a renewed focus on fundamentals.
This past summer, markets in the emerging economies went on a roller-coaster ride as investors worldwide started selling risky emerging-market assets. What led to a “sky is falling” reaction among investors was the indication by the Federal Reserve Bank of the United States (Fed) of a possible reduction in its monetary policy stimulus on May 22, 2013, which somewhat eased after the Fed deferred its decision to taper its monetary policy stimulus on September 18, 2013.
While panic gripped almost all of them, the economies that belonged to the weaker end of the performance spectrum were punished the most by investors.
What was noticeable was that the degree of impact during this period of heightened uncertainty (PoU refers to the period between May 22, 2013 and September 18, 2013) differed for different emerging economies. The extent of vulnerability in some of the emerging economies made it evident that risk perception of investors associated with the emerging economies differed substantially due to their relative performances and economic fundamentals. While panic gripped almost all of them, the economies that belonged to the weaker end of the performance spectrum were punished the most by investors.
The Fed’s decision not to taper turned out to be short term when it decided to reduce its stimulus in the FOMC meeting in December.1 In the following 10 days, Turkey was the first emerging market to experience a 5 percent depreciation in its currency against the US dollar and a 10 percent fall in the equity index. Will other emerging economies soon follow suit? Will there be a repeat of the events experienced last summer? Are the emerging economies fundamentally strong enough to deal with the uncertainty associated with Fed’s actual tapering? In the last two decades, the share of emerging economies in global output has increased from 35 percent to over 50 percent. The global growth momentum during 2003–2011 was driven primarily by these fast-rising emerging economies, as the growth contribution of advanced economies took a back seat. However, if these emerging economies are hurt by heightened global uncertainties, would that put an end to the era of outperformance of emerging economies? This article attempts to answer some of these questions by comparing the economic fundamentals of 12 emerging economies, spanning all continents.
A recap of the events since May
It all started in May with a taper tipoff by the Federal Reserve Chairman Bernanke, which triggered turmoil in the market. Investors were unaware of its inevitability, but sooner-than-expected tapering of the Fed’s quantitative easing policy made them wary of the potential impact of liquidity shortages and uncertainties in emerging markets that have grown accustomed to unprecedented flows of short-term capital from abroad. Ironically, a close assessment of Bernanke’s speech made to the Joint Economic Committee, US Congress, on May 22, 2013 reveals that there was no formal mention of the Fed’s tapering. What markets reacted to was a statement made by Bernanke in the question-and-answer session after the speech that said, “In the next few meetings, we could take a step down in our pace of purchase.” In the months that followed, uncertainty regarding the Fed’s policy heightened as some of the economic data pointed to a better recovery in the United States; Bernanke also reaffirmed in some of his speeches in the following two months that tapering may happen sooner in light of an improving economy. However, it was the investors who got ahead of themselves, anticipating with confidence that the Fed would announce its tapering in September’s meeting. Investors worldwide started pulling money back to the United States by selling risky assets, mostly those of the emerging markets, in favor of US securities as well as cash. Consequently, almost all emerging economies experienced a sudden capital outflow that sent shock waves to their stocks, currencies, and bond markets. To the markets’ surprise, the Fed unexpectedly refrained from reducing the $85 billion pace of monthly bond buying in its much-anticipated FOMC meeting on September 18, 2013. This decision to maintain quantitative easing helped bonds, stocks, and currencies in emerging economies to claw back up to restore their summer losses.
However, the relief was short term, and the Fed finally announced on December 19, 2013 that it would start tapering its massive stimulus program, showing confidence in the recovery of the US economy and the job market. Beginning in January, the Fed will add $75 billion per month in agency-mortgage-backed securities and longer-term securities to its holdings, down from the $85 billion monthly asset purchases it has made for more than a year.2
The differentiated response
While all 12 emerging economies were affected during this PoU, the extent of volatility differed substantially among these economies. The four panels in figure 1 analyze the year-to-date experiences in the currency, bonds, and stock markets and the currency reserve situation of the emerging economies as well as volatility during the PoU. Figure 1a shows that, while local currencies in all these economies depreciated against the US dollar during the PoU, currencies in India, Brazil, Indonesia, Turkey, and Malaysia fell by double digits. Extreme volatility in currencies compelled the policy authorities of these economies to intervene with urgency in order to correct the course of depreciation. India is the only economy to have gained some of the ground it lost after the deferment of the Fed’s tapering announcement in September; currency is still depreciating for rest of the economies. For China and South Korea, the currency appreciated this year, despite a brief fall during PoU.
In contrast to the impact on currency, only a few of the emerging bond and stock markets suffered an extreme adverse impact due to the fierce selloff as shown in figures 1b and 1c. While high demand for US Treasuries drove down bond rates, only a few economies witnessed a sharp widening of the interest rate spread with respect to the 10-year benchmark rate of the United States. Turkey, Indonesia, India, and Brazil saw a sharp rise in the interest spread while it narrowed in Russia, South Korea, Malaysia, and China during the PoU. Indonesia and Brazil—whose interest rates spread vis-a-vis the 10-year benchmark rate of the United States had been rising prior to the PoU—saw the gap widening further during and after the PoU.
Stock markets in Turkey, Indonesia, the Philippines, and Thailand were strongly hit during the PoU. Fierce asset selloff and a sudden outflow of portfolio investment led to a sharp fall in equity prices. For the Philippines, Malaysia, and India, there was a severe reversal of their stock market trends during the PoU. However, markets in Malaysia and India were back on the rising track after September and exceeded their levels prior to the PoU. Surprisingly, markets in South Africa, Mexico, Russia, South Korea, and China, which have been falling prior to PoU, improved during the PoU and continued to strengthen after that period. This probably indicates that a portion of capital withdrawn from all other nations flowed into these economies.
Due to strong domestic currency depreciation, currency reserves fell for most of the economies during the PoU, except for Mexico, South Korea, and China (see figure 1d). One of the reasons for this fall was the selling off of US currencies by central banks in order to halt the local currency depreciation. Reserves fell the most in Indonesia, the Philippines, and India due to high currency and stock market vulnerabilities, as shown in the panels above. While the Philippines gained some of the ground it lost after the Fed’s announcement to delay tapering, reserves have continued to fall in India and Indonesia.
Figure 2 summarizes the market responses of the 12 emerging economies discussed above during the PoU and their relative positioning in terms of the degree of impact. Markets in Indonesia, India, Turkey, and Brazil were the worst affected among the 12 economies, while China and South Korea were relatively unaffected. India saw correction in two of its markets since September.
Checking the economic fundamentals
The question is why markets in some economies were battered during the PoU while others remained unscathed. The reason could be that either investors were irrational, which may not be completely untrue, or they cautiously moved out of countries whose economic outlook did not look promising in the long run. The second reason underlines an investor’s risk perception of an economy as an investment destination. These perceptions are based on various economic and non-economic factors. The four panels of figure 3 elaborate on a few selected economic fundamentals and the relative economic performance of the 12 emerging economies and analyses their risk profiles relative to each other. The color of the country represents the degree of relative risks; red indicates relatively high risk, yellow indicates relatively moderate risk, and green indicates relatively low risk.
Among the most important criteria for assessing the risk of an economy as an investment destination are its growth outlook and its stability.
Among the most important criteria for assessing the risk of an economy as an investment destination are its growth outlook and its stability. Economies with high growth and low inflation are usually deemed as low-risk and high-return investment destinations. Strong growth increases the probability of higher returns on investment, while low inflation prevents the erosion of their investment returns in the long run. In figure 3a, the economies are positioned relative to each other based on their real economic growth and consumer price inflation in the latest quarter 2013 Q3. China, Philippines, and Malaysia are economies with relatively high growth and low inflation. On the other hand, Brazil, Russia, and South Africa are at the other extreme of growth and inflation. Though India, Indonesia, and Turkey have relatively higher growth, these economies have also been experiencing very high and persistent inflation in the last couple of years. As a result, these economies are experiencing high uncertainties with respect to their growth sustainability and returns on investments.
A second important consideration is the governance, political situation, and fiscal responsibility of the government of these economies. Figure 3b positions the economies with respect to their current political and policy uncertainties. Transparency in policy making and bureaucracy, measured and ranked by the IMF,3 is high for most of these economies. However, for some economies, political uncertainties due to the impending elections at the national levels are resulting in policy paralysis and delays in the implementation of meaningful reforms. Six of the 12 nations are up for election in the next two years. This has implications for the stability of the institution as well as the direction of actual policy decisions, which tend to be sub-optimal.4 Not only does a change in governance influence policy implications, even the margin of victory of the winning parties (electoral margins) can also matter in determining policy risks.5 For example, India, Indonesia, Turkey, and South Africa will have their government elected in 2014. However, uncertainty in Turkey and South Africa is lower because their present leaders are expected to remain dominant in the future. On the other hand, current ruling parties in India and Indonesia are losing support and public confidence.
For India, Malaysia, and Brazil, the fiscal deficit has been widening, putting additional pressure on their high levels of public debts (see figure 3c). A bout of populist spending in any year, especially for economies that are close to an election, can throw the budget management off the balance, raising the probability of a sovereign default.
The last panel depicts the relative volatility of domestic currency to that of the inflows of portfolio investments in these economies from 2009 until the first half of 2013. While currency valuation can be an important factor in determining the direction of capital flows,6 strong capital flows also influence the valuation of currency. Hence, their relationship runs in both directions. Again, volatility in capital flows may not be the only factor resulting in currency instability. The objective of this comparison is to indicate whether or not the monetary policies were effective enough to stabilize currency after the financial crisis when capital flows turned highly volatile. While none of the economies belonged to the region of high volatility in capital and currency during this period (this does not include the period after June 2013), monetary policy appears to have been relatively less effective in Turkey, Russia, South Africa, Brazil, and India.
Most of the emerging economies also suffer a skewed balance of payments. Figure 4 compares the current account balances of the emerging economies and the direct investment inflows during the second quarter of 2013, the latter representing a stable source of investment and revenues for the economy.7 Economies like Turkey, Thailand, South Africa, India, and Indonesia have reported a large and growing current account deficit as a percentage of GDP. However, the proportion of direct capital investment is mere a fraction of GDP. In other words, a very small proportion of the capital account is being invested in production and building long-term assets in these economies. Although these economies have a strong reserve balance to finance their imports, a rising deficit can quickly deplete their exchange reserves in the absence of a stable source of investment income. This is not simply a possibility; the turmoil this past summer is an evidence of that.
Digging deeper into structural inadequacies
It is evident from the above two sections that economies with poorer fundamentals and weaker policies have been hit harder. Digging deeper, it is apparent that poor fundamentals are due to structural problems. The three panels of figure 5 show that most of the economies have grown in terms of market size, but they lack basic infrastructure to support the market.
Some of these economies are highly uncompetitive (as ranked by the IMF, Global Competitiveness Index), and business and investment decisions are often sub-optimal. According to figure 5a and 5b, India, Russia, Brazil, Philippines, Mexico, and South Africa are relatively poor in terms of infrastructure and competitiveness. Over the last two decades, these economies have successfully moved away from agriculture to manufacturing and into the services sector. However, most of these economies lack the ability to innovate and the knowledge to broaden their scope of production and income generation.
The last 10-odd years have been a good run for emerging markets. The remarkably rapid growth of the emerging economies during 2003–2011 marks the biggest economic revolution in the modern history. Growth in most of the emerging economies gained substantially due to a combination of an inflow of excessive and cheap capital from advanced economies and high commodity prices fueled by strong growth and rising demand in China.
But for some economies, the problems are more deeply rooted, and short-term fixes will probably not help.
But now, many of these emerging economies face severe economic crises as global uncertainties increase. This implies that these economies have to rely more on economic fundamentals in order to grow. However, a tightening of global financial conditions in recent months has exposed a divergence in the fundamentals of these economies.8 The Federal Reserve’s decision to postpone the announcement of reducing monetary policy stimulus in September 2013 might have eased the tension for the moment and bought some time for these economies to bounce back. But for some economies, the problems are more deeply rooted, and short-term fixes will probably not help. The Fed’s recent announcement to taper implies that global uncertainties are here to stay. The question is, can these emerging economies sustain their growth story in the future? Are the emerging economies losing their brand appeal? While we continue to ponder over these questions, I leave you with a relative risk positioning of these 12 economies, based on the economic fundamentals discussed above.