Wednesday, 19 September 2018

IMF/World Bank 2007: Full steam ahead

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The world’s emerging markets are enjoying near-boom conditions, despite the turmoil spreading out from the sub-prime mortgage crisis in the US. Emerging markets have lower vulnerability to external shocks than ever before, writes Simon Knapp, senior economist at Oxford Economics.

Despite a subdued performance by the US economy, GDP growth in the emerging markets as a whole should be close to 7% in 2007, well above expectations at the start of the year. This represents the fourth consecutive year of very robust expansion.

Out of 21 key emerging economies, growth estimates have risen in 14 (with substantial upgrades in China, India and Russia), remained broadly unchanged in five, and downgraded in only two – Thailand (affected by 2006’s military coup and frequent policy changes) and Mexico (the country most obviously affected by a weak US).

In many cases the upgrades have resulted from accelerating domestic demand; while a reasonably healthy Japanese economy and a stronger-than-expected Eurozone have boosted external demand for a number of countries.

We expect only a marginal slowdown in aggregate growth in 2008. A modest pick up in the US through the course of 2008, with cuts in policy interest rates helping to offset the impact of problems in the credit and mortgage markets, should help to underpin world trade growth and several export-dependent Asian economies, while a continuation of 11%-plus growth in China should partially offset the gentle deceleration of various economies that reached their cyclical peaks in 2007 (either due to a moderate policy tightening or a decrease in the boost from high commodity prices).

There are a number of factors that explain why growth in the emergers has been so buoyant over the last few years. In general, countries have continued to “open up” to the world economy, realising some of the potential gains from external trade, the benefits of improved manufacturing, managerial and financial practices linked to inflows of foreign direct investment and the spurring on of domestic entrepreneurial activity. This process has played a key part in the long period of dynamic Chinese growth and in the more recent growth burst in India.

Monetary and fiscal frameworks

Another key factor for many countries, particularly those that have previously suffered from wild swings in their economies and high inflation, has been the implementation and following of a rigorous macroeconomic policy framework, involving targets for government budget balances and inflation. As this policy has been sustained it has resulted in generally low inflation and reduced interest rates, while the stable conditions have assisted corporate planning and encouraged private sector banks to lend to a wider range of households and companies, raising credit growth and boosting domestic demand.

A notable beneficiary of this process at the moment is Brazil. While interest rates in the “developed” economies have moved higher in the last 18 months, Brazilian interest rates have been steadily reduced to their lowest nominal level in decades without hurting the exchange rate at all. This credibility with the financial markets was “earned” by the central bank’s preparedness to raise interest rates sharply in both 2002/03 and 2004/05 when the prospects for inflation looked worrying. Looking forward into 2008, Turkey should also experience the “rewards” of its solid framework (as it did in 2004 and 2005) when inflation falls towards its target and allows an unwinding of the 2006 interest rate rises (provided that a current account financing crisis is not triggered by a violent correction to global investor sentiment).

More generally, the environment of robust economic growth and moderate inflation has led to a surge in credit expansion in 2006 and 2007, and this has further scope to increase, particularly in countries where the stock of lending was initially low compared to the size of the economy (India, Latin America and central and eastern Europe). Of course, too rapid credit growth could risk putting upward pressure on inflation, and this is a worry in Russia (showing a 53% rise in credit in July) and India (around 24% in July). In both cases macro policy frameworks are less immediately transparent than in Brazil or many other emergers, while their economies are less amenable to government influence than China’s; though in India’s defence, the central bank has implemented a series of tightening moves (higher interest rates and reserve requirements) to reduce the danger.

While many economies have been keen to reap the benefits of “opening up” to the global economy, sometimes the possible gains from these have clashed with domestic political considerations – in which case the latter have usually won out. Examples of this are the continuing obstacles to FDI in various parts of the Indian economy and the problems of foreign investors in South Korea trying to realise the gains from buy-outs made when Korean assets were cheap.

To a large extent this pattern mirrors the fact that for most emerging economies, structural reforms, designed to raise growth in the long term – for example, to improve the working of labour, product and energy markets, open up the services sector to greater competition and improve taxation and pension systems – have all fallen a long way down the policy agenda in recent years. The lack of effort in this area (Mexico being perhaps an exception in the last six months or so) at a time when growth has been generally very robust (and when “losers” from reforms could have been partially compensated) could prove to be a costly mistake if the global economic background becomes much less benign.

Build up of FX

Aside from the continuation of a high pace of economic growth in the emerging markets the other notable development this year specific to the emergers was the continued rapid accumulation of foreign exchange reserves prior to August’s turmoil in global markets. Between the end of 2006 and the end of June, Chinese reserves increased by US$266bn, Brazil’s by US$61bn, Russia’s by US$102bn and India’s by US$36bn. Moreover the same pattern occurred in many other, much smaller, economies. In total, the emergers as a whole (excluding OPEC) may have seen their reserves climb by US$550bn over this six-month period as countries sought to dampen the pressure on their exchange rates to appreciate against a weak US dollars.

On our estimates, this compares with an aggregate current account surplus over the same period of about US$220bn, implying net capital inflows to the emergers of US$330bn – money that the central banks are effectively “sending back” to the rest of the world by their purchases of reserve assets (predominantly the government securities of the leading “developed” economies).

In the case of China, Russia, Malaysia and Singapore continued substantial current account surpluses were a factor (as it was in Thailand where the current account has swung from a deficit of 4.6% of GDP in 2005 to a prospective surplus of 4.7% of GDP in 2007) generating upward pressure on currencies. In addition a surge of capital flows (FDI and, particularly, portfolio) from investors in the “developed” economies added to the impulse, perhaps attracted by the “high growth” story of the emergers. Indeed, for many emergers the latter development was the dominant factor, as countries with only relatively modest current account surpluses or even significant deficits saw huge rises in reserves over the period. For example, the US$61bn rise in Brazil’s reserves during the first half of 2007 compares with a current account surplus of just US$4.4bn over the same period. Similar pressures have been felt by smaller economies. Colombia saw a US$5.5bn rise in reserves in the first half of the year, at the same time as a likely current account deficit of US$2.5bn and a 13.5% appreciation of its exchange rate.

Although most emergers (apart from those in central Europe) during this period intervened in the FX markets to prevent excessive currency appreciation, the results of this policy varied widely. The pace of appreciation in the Chinese renminbi may have marginally accelerated but the Chinese currency rose only 3.1% against the US dollar between the end of 2006 and the end of July this year, probably pretty much in line with what the government would have been wanting. By contrast, the scale of the capital flows pushed the Brazilian Real to a level stronger than the authorities would have liked (considering inflation was already under control) – up 13.9% over the same period (and up 41% since the end of 2004), despite steady cuts in interest rates and unprecedented intervention.

Having been keen to maintain a fairly stable rupee, in March the Indian authorities decided that it was more prudent to allow the currency to appreciate in the face of large capital inflows (and so help reduce import prices) than intervene in unlimited amounts that would boost liquidity at a time when inflation pressures were already considerable. However, in June and July they reverted to their original policy of keeping the rupee stable through heavy intervention; between the end of December and the end of July the rupee gained 9.4%.

Of the largest emerging economies, Russia allowed the least appreciation against the US dollar in the first seven months of 2007, up just 2.9%. Despite the evidence of building inflation pressures the authorities have appeared more concerned about limiting the damage to the competitiveness of the country’s manufacturing sector.

The break-out of the crisis in US sub-prime mortgages into the wider global credit markets during late July and through August brought the surge in capital inflows to the emergers to at least a temporary halt, judging by the weekly FX reserves data in Brazil, India and Russia and the behaviour of their respective currencies. And although the “high growth” story of many emergers (particularly when combined with a stable macro policy framework) will remain an attraction for investors for many years to come, there seems little doubt that there was a degree of momentum-chasing by investors in many emerging market assets in the first half of the year.

This could lead to much greater outflows from the emergers than has hitherto been the case if the crisis in the credit markets escalates and leads to a generally risk-averse global financial environment.

In this event the pressure on emerging currencies to appreciate against the US dollar would be narrowed down to those either in substantial current account surplus (China and Russia, for example) or to those countries where there was still a particularly compelling growth story (possibly India). For those economies with significant current account deficits – such as Turkey and South Africa – they would have to rely on the support of their policy frameworks, their FX reserves and their ability to attract FDI inflows to ensure that they did not experience a destabilising drop in their currencies.

Pressure on China

Irrespective of global financial conditions it seems highly likely that the pressure on China to speed up the appreciation of its currency against the US dollar will continue: this pressure may be intensified by the IMF’s recent decision to revise its rules on bilateral surveillance over members’ policies and clarify its approach to assessing whether a country is manipulating its exchange rate (defined as the country securing a fundamental exchange rate misalignment in the form of an undervalued exchange rate with the intention of boosting net exports). We expect that the current account surplus will move over US$300bn this year and stay above that level in subsequent years.

From the time China changed its exchange rate regime in July 2005 to the end of July 2007, the renminbi appreciated by 9.3% – this compares with a gain by the Korean Won over the same period of 12.5%, 24.5% by the Thai baht, 9.9% by the Malaysian ringgit and 11.4% by the Singapore dollar (the Taiwan dollar and the yen weakened by 3% and 4.7% respectively).

Of these Asian economies, only Korea has a current account position anywhere near balance, plus the Korean Won had already strengthened considerably between early 2002 and mid-2005. For all the others, except possibly Thailand where a significant part of the move into external surplus reflects a slump in domestic demand, it would be hard to argue that their exchange rates should not appreciate more against the US dollar in an effort to reduce the global imbalances (even though the effects of these currency changes would likely be modest, at least in the short term).

In any event Chinese reserves are set to expand considerably. This could have both domestic and external repercussions. Over the last year the impact of soaring reserve accumulation on liquidity in the domestic economy has been limited by a steady rise in banks’ reserve requirements, from 8.5% in September 2006 to 12.5% a year later; if overall growth remained high and some inflationary risks persisted then reserve requirements would have to be raised even further, eating into banks’ profitability. Externally, the likely rise in reserves would give the Chinese even more money for its new sovereign wealth fund (to be allocated US$200bn at first) which will have a much wider investment remit than the traditional reserve holdings of mostly US treasuries and agency bonds. As well as possibly being spread across a wider range of assets and currencies than the existing stock of reserves, thereby supporting the US dollar to a lesser extent, large investments by the fund in certain sectors and countries could raise the political “temperature” and have consequences for bilateral trade relations. The same is true of Russia’s prospective sovereign fund.

Less vulnerability to external shocks

For the four largest emergers a bout of instability in the global financial markets is unlikely to have a significant impact on their economic performance, unless it was so dramatic that – even after offsetting policy actions – it knocked the “developed” economies sharply off course. Domestic demand growth should remain vigorous in all four, while Brazil, previously vulnerable in such a situation, now has the cushion of massive FX reserves and a solid policy framework.

Meanwhile for most emergers – despite very high oil prices – the threat from inflation appears relatively modest and largely focused on food price inflation. Moreover for several, including China, India and Russia, if it proved necessary, allowing a faster pace of exchange rate appreciation would help to dampen inflation. In China’s case, opening up the range of eligible foods for importing would also assist in the battle against inflation.

The issue of rising food prices could pose an ongoing problem for the emergers for quite some time – as prices are driven up by farmers growing biofuels rather than food – and they are more vulnerable than the “developed” economies which spend a smaller percentage of income on food. However, it could prove a more severe headache for some countries in the short term. For example, rising food prices could result in unwelcome CPI inflation developments in Turkey and South Africa, making them more vulnerable to a financing crisis in adverse market conditions, and thereby exposing them to a potentially sharper slowdown in growth.

Otherwise, the main risks for the leading emergers are likely to come from within, although none stand out as particularly likely in the short term. Problems could, for example, come from companies and governments misjudging the strength of their respective economies towards the end of a long and boisterous cycle. The most dangerous possibility (not only for the country but also for the world economy) might be a sharp slump in Chinese investment post the Olympics, given its very high weight in GDP. Another risk might be an overly complacent policy stance by the Russian authorities, one that allowed a boom in domestic demand to develop to such an extent (fuelled by high oil and gas revenues, and surging credit) that it led to a sharp acceleration in inflation. And the development of serious problems in either of these two economies or in India would significantly dent the “growth” story of the emerging markets as a whole.

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