by Anders Aslund, Peterson Institute for International Economics
Op-ed in Bloomberg
September 10, 2013
Morgan Stanley has named Brazil, India, Indonesia, Turkey, and South Africa the "fragile five." They share some common characteristics: All took in excessive short-term international financial inflows, which enticed them into accepting excessive current-account deficits for too long. High economic growth has made their governments complacent, even as rising exchange rates undermined their competitiveness. Now their growth rates and exchange rates are falling.
The catalyst, though not the actual cause, of the current market developments was the prospect of a rise in US interest rates that began to take shape with Federal Reserve Chairman Ben S. Bernanke's May 22 talk about "tapering" quantitative easing. Since then, the US 10-year Treasury yield has surged by more than 100 basis points and continues to rise, even though the Fed hasn't begun to reduce the pace of its securities purchases.
Bond yields of vulnerable emerging economies have risen faster. Investors had always known that the zero US interest rates would eventually normalize. Given that the Fed inflation target is 2 percent, and a real 10-year bond yield of 3 percent used to be the average, it is reasonable to expect the bond yield to rise to about 5 percent.
Emerging economies are in trouble because the credit and commodity booms that brought high rates of economic growth are unsustainable. Many have received large volumes of fluid international capital. If their exchange rates fall rapidly, large volumes of money will float out and inflation may surge. If they defend their exchange rates with reserves, those will shrink fast. In either case, emerging economies may have to cope with the sudden end of international financing.
The global investment ratio is bound to decline significantly as real interest rates rise. In recent years, China has accounted for a large share of global investment, and in 2009, fiscal stimulus pushed its investment ratio to an extreme level of 48 percent of GDP, from an already high rate of 35 percent in 2000. That isn't sustainable. The Chinese investment ratio is bound to fall by at least one-tenth of GDP, which would reduce the global investment ratio, too.
Similar trends were visible at the beginning of Latin America's lost decade, in the early 1980s. As then, the world is now approaching a downward turn of two long cycles, the 15- to 20-year long financial cycle and the even longer commodity cycle. Emerging markets benefited from both the credit and commodity cycles that have now peaked and begun a long-term decline of a decade or so.
The macroeconomic situation of today's emerging economies is far better than it was in some of the Latin American countries in the 1980s. Argentina, Brazil and Peru had large budget deficits and pegged exchange rates, leading to hyperinflation and default. Today, major emerging economies have low inflation, limited budget deficits, mostly floating exchange rates and large international reserves. It's worth recalling that the same was said about the United States and Europe before the recent recession.
Demand for commodities is bound to decline with less investment. In recent years, China has accounted for about 40 percent of global consumption of major commodities. The long commodity cycle peaked in 1980, and it reached a new peak in 2008. After the oil shock of the 1970s, oil prices were very high from 1973 until 1980. But from 1981 until 1986, they fell steadily as energy consumption declined.
We are in a similar situation today. Global commodity prices rose sharply from 2003 until 2008, and they maintained a high level until 2012 because of the very loose global monetary policy, which encouraged both investment and speculative positions in commodities.
After such a long period of high energy prices, greater energy savings are likely. Technological revolutions such as shale gas, tight oil, deep-sea drilling and liquefied natural gas production have generated a far greater supply effect than in the 1980s. This year, prices of almost all commodities have declined, and are likely to continue to fall for at least half a decade.
In the early 1980s, the world experienced similar critical trends: rising global interest rates (both nominal and real), declining investment ratios, and lower commodity prices. Poorly managed emerging economies were battered then, and they are likely to be affected again.
Emerging economies with large current-account deficits, foreign indebtedness, budget deficits, and public debts would be the first to suffer. The turmoil could then spread to large commodity exporters, such as Russia, Brazil, and South Africa. China, by contrast, would benefit from lower commodity prices, but it appears overleveraged, with a huge bank credit that amounts to twice GDP.
Global trends don't change very often, but when they do change, they do so sharply. From 2000 to 2012, emerging economies grew 5.9 percent a year on average; US growth was 1.8 percent. This led many people to declare the victory of the emerging economies over the West. But the high levels of emerging-market growth were artificial, caused by the global credit boom (the Greenspan put) and then huge credit transfers from the West.
The pre-boom period, 1980–2000, may be more representative of a normal period. Then, the emerging economies grew an average of 3.7 percent a year, significantly faster than the United States, at 3.2 percent a year. That meant increasing economic divergence, because the United States increased its advantage given the far lower staring level of the emerging economies.
As a consequence of these global developments, in the early 1980s, the United States experienced large currency inflows that drove up the trade-weighted US dollar exchange rate by 40 percent from 1980 to 1985, and lifted stock and bond prices. This is likely to happen again. Global economic growth will probably moderate with deleveraging and financial turbulence in the emerging economies, while the United States will proceed with a normal growth rate of 2.5 percent to 3.5 percent a year.
In Europe, the long recession has brought fiscal consolidation and substantial structural changes, such as labor market reforms. The continent is now returning to growth, which is likely to be accelerated by those tough reforms. For a decade or so, the West could take the global economic lead once again as it did in the 1980s.
Many emerging economies that ignored necessary structural reforms during the boom could experience low growth for a prolonged period. They have allowed state and crony capitalism to thrive, locking themselves into a middle-income trap. Those that carried out sound reforms—Central and Eastern Europe, Chile, Mexico, Colombia, and South Korea—are likely to do well.
Eventually, after making enough mistakes, the struggling emerging economies will be forced to undertake the necessary reforms. In Latin America of the 1980s, this involved democratization, liberalization, macroeconomic stabilization, and privatization, which took at least a decade. The next round of reform will be hard, too, but change is the only way forward.
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