Despite the uncertainty looming over the global economy, one thing seems certain: developed economies won’t be driving global growth in 2012. With much of industrialised world struggling to keep above water, the onus this year remains on faster-growing emerging economies, principally in Asia, to prevent a major global economic downturn.
That the emerging world is better insulated today than from previous crises has become a familiar refrain in recent years, ever since the global financial crisis first exploded in 2008. Analysts increasingly argue that growing trade links between emerging market economies, together with continued strong growth across much of Asia, Latin America and Africa, and a greater degree of policy flexibility than many of their rich-world peers, stand emerging economies in good stead to combat a renewed downturn in the developed world.
But the reality is far more complex: fast-growing emerging economies, most notably China, are facing severe domestic and external pressures on growth. And the threat of a fresh global banking crisis has raised the risk more broadly of a severe liquidity drain in emerging as well as developed markets.
DEVELOPED MARKET FALLOUT
For all the talk of decoupling, the eurozone crisis is already taking its toll on emerging markets. This is most evident in the region with the closest trade and economic ties to the eurozone: Central and Eastern Europe (CEE). The consensus among analysts is now that much of the region will slip back into recession in 2012, with the possible exception of Turkey and Poland, thanks to both countries’ relatively robust domestic demand and developed domestic banking sectors. If Germany’s export machine falters, the impact could be catastrophic for many CEE economies: exports to the eurozone account for the bulk of the region’s trade.
But beyond trade linkages, the biggest risk is the prospect of significant deleveraging by Western European parent banks operating in the region. Foreign banks account for more than 80% of total bank assets in many of the region’s economies, both in smaller markets such as Bosnia, Albania and Lithuania, and in some of the region’s more systemically important economies, notably the Czech Republic and Hungary. Nomura estimates that there will be €13 billion in outflows from banks in emerging Europe in 2012, with Hungary, Serbia, Romania and Bulgaria likely to be the most adversely affected; other analysts place the figure even higher than this.
With European banks tapping the European Central Bank for tens of billions of euros by the day in emergency credit lines in early January, and with shares in major, systemically important European banks taking a hammering, the risk of a severe European banking crisis has hardly abated. In such circumstances, parent banks may have no choice but to withdraw liquidity from peripheral markets in central and eastern Europe.
Emerging market regions further afield have also already begun to feel the effects of the eurozone crisis. Exports to the eurozone from key trading partners such as China have shown double-digit declines in recent months, reigniting concerns about a repeat of the situation in late 2008 and early 2009, when exports fell off a cliff, rapidly dragging GDP growth across much of the emerging world into negative territory. And given that global manufacturing supply chains are so tightly knit, a slowdown in exports and manufacturing in China could have a severe knock-on effect on commodity-producing nations in Africa and Latin America.
Despite its burgeoning trade links with Asia, Latin America remains extremely vulnerable to a slowdown in the US – a scenario that would grow more probable if the eurozone crisis worsens.
While US GDP growth picked up throughout 2011 – and is expected to have risen to around 3% in the final quarter of the year – growth is widely anticipated to slip this year in the face of fiscal tightening, a European recession, and massive policy uncertainty around November’s presidential election. As Bank of America Merrill Lynch analyst Ethan S. Harris wrote in a recent research report, “if the Eurozone crisis spins out of control, it will likely push the US economy into recession.”
No region is immune from the European fallout, analysts stress. Even Gerard Lyons, chief economist at Standard Chartered and a flag bearer for the strength of emerging market economies, acknowledged in his annual outlook that “2012 is likely to highlight the fact that ... no region is fully decoupled from events elsewhere”.
HOMEGROWN PROBLEMS
While attention has largely been focused on the likelihood of recession in developed economies, the big emerging economies that have been the primary drivers of global growth over the past decade are also running into problems at home.
Indian policymakers have revised down their optimistic 9% growth forecasts amid stubbornly high food and structural inflation, a mounting deficit and growing frustration at the slow pace of reform and the continued prevalence of corruption. Foreign investment has dried up, the Bombay stock market was the worst performing of all major emerging market bourses in 2011 and the rupee has hit a series of all-time lows against the dollar. Despite signs that inflation may finally be moderating, the government’s heady predictions of China-esque near double-digit growth appear increasingly far-fetched.
More worryingly still, China bears have been growling louder than usual of late – and seemingly with good reason.
Mounting concerns about the banking system, local government debt and the health of China’s property sector have revived warnings that the Chinese economy is faces a growing risk of a hard landing. Recent declines in property prices and warnings from Chinese property developers have heightened fears that the country is facing its first property crash in modern memory – with potentially devastating consequences for the broader economy.
A prolonged property downturn would exact a hefty toll on the overall economy, given the sector’s importance; last year, real estate construction accounted for 13% of GDP and more than 25% of fixed-asset investment, while the property sector accounts for almost half of Chinese steel use, and is a major driver of demand for other commodities, such as copper. Given China’s growing status as the leading trading partner for many commodity-producing nations across the developed and emerging world, how China’s property market plays out over the coming 12 months may actually have a larger impact on global growth than the outcome in the eurozone.
A protracted slump in Chinese real estate would also heighten concerns about burgeoning levels of local government debt. Land sales are the largest revenue earner for Chinese local governments, many of which are already heavily indebted as a result of the massive investment-driven stimulus package unleashed in late 2008. Third-party figures released in early January show that the number of failed local government land auctions trebled in 2011, while revenue from land sales across 130 cities was down 13% last year.
Long-term China bears such as hedge fund managers Jim Chanos and Hugh Hendry, as well as economists such as Nouriel Roubini, have long suggested a property slump would be the most likely trigger for a Chinese hard-landing. There is mounting evidence that this scenario may be playing out. Added to this, a series of high-profile local protests and corruption cases have raised fears that social unrest may become increasingly disruptive in 2012 – particularly worrying for Beijing as it gears up for a leadership change this year.
But there are a number of factors which could limit the fallout of a property slowdown, analysts say: most Chinese homebuyers have very little, if any, leverage or debt; demand for residential property remains high and supply at all but the very high end of the market remains relatively tight; and the Chinese government’s ambitious affordable housing programmes, which the leadership in Beijing has prioritised in its latest five-year plan, will at least partially compensate for any drop-off in construction activity. Falling land-sale revenues may further crimp local government revenues, but even if total outstanding local government debt liabilities are combined with the central government’s current debt burden, China’s debt to GDP ratio will still compare favourably with almost all other major economies globally. China, on this view, has sufficient ammunition to cope with most of these scenarios for the foreseeable future.
Whatever the case for its housing market, China’s economy faces a slowdown in 2012. Exports declined on a quarterly basis in November, led by a sharp drop-off in exports to the Eurozone and dragging down the trade surplus, PMI numbers for December showed a third consecutive monthly fall in new export orders, while manufacturing output remains weak. Industrial production and fixed-asset investment growth is also slowing, prompting many analysts to revise down their GDP forecasts for 2012, in some cases to below 8%.
Under almost all scenarios, China next year will likely record its weakest economic growth in a decade. Near double-digit Chinese growth has underpinned the global economy over the past decade. A slowdown, even if it proves to be a soft landing, will therefore be a drag on global growth, especially given the grim outlook in Europe and the US.
Furthermore, mounting domestic concerns pose severe risks in a number of other emerging economies. Hungary in particular appears to be teetering on the brink of a political and balance of payments crisis that risks exacerbating the negative impact of the gathering eurozone crisis and could further add to pressures on Western European banks with a significant presence in Hungary. Investment growth, credit and consumption in Brazil have dried up in recent months, dragging GDP growth into negative territory. Growing political uncertainty in South Africa continues to cloud the economic and investment climate, before even considering the high long-term unemployment rate in Africa’s largest economy. Finally, mounting political uncertainty in the Middle East in the wake of last year’s Arab Spring, as well as heightened tensions over Iran and political uncertainty in Venezuela, threaten severe oil price volatility, further complicating the outlook for the year ahead.
None of this augurs well for emerging market economies in 2012. Almost all analysts predict that emerging world growth will slow in 2012, even though it will still significantly outstrip that of the industrialised world. As HSBC’s chief emerging market economist Pablo Goldberg puts it, “the world of the future, even in the best case, is one of slowing growth.”
POLICY TIGHTROPE
Against this backdrop of domestic and external risks policymakers in emerging markets are grappling with how best to plot a course for the year ahead which maintains growth while avoiding inflation and guarding against volatile capital flows.
For much of last year, the priority for most emerging market policymakers was to tame inflation and prevent overheating. As recently as six months ago, there were genuine fears that policymakers were behind the curve in combating rising inflation, and had been too slow in unwinding expansionary fiscal policies introduced in the wake of the 2008 financial crisis. There was widespread concern at the range of unorthodox, macro-prudential measures employed in an attempt to ward off sharp inflows of speculative capital, driven by quantitative easing in Europe and the US.
Within the space of a few months, policy priorities have shifted radically. Inflation appears to have peaked across much of the emerging world, while policymakers are publically warning about the dire implications of a renewed recession in Europe and the US. The emphasis is now squarely on preserving growth and preventing a repeat of 2008 and early 2009, when exports and GDP growth across the emerging world fell off a cliff.
Brazil was the first major emerging market economy to buck the trend, surprising the market with a 50 basis-point rate cut in August. By the end of last year, most large emerging economies had followed suit, in some cases cutting interest rates, in others, relaxing controls and restrictions introduced in 2010 and early 2011.
With many emerging economies having already revised down their GDP forecasts, most analysts expect more of the same during the first half of 2012. Growth is likely to remain the priority. And while policymakers have less room for manoeuvre than they did in the grip of the global financial crisis three years ago, most still have significant scope for action. Most emerging nations having at least partially unwound stimulus policies and maintain lower debt to GDP ratios than their developed market counterparts; policymakers in many regions continue to have significant fiscal, as well as monetary, ammunition at their disposal in the event of a renewed severe global downturn – and most would likely be willing to use at least some of it. “In the West, the fundamentals are poor, the policy cupboard is almost empty and confidence has been shot to pieces. In contrast, across the emerging world, the fundamentals are good, the policy cupboard is almost full and confidence is likely to prove resilient,” StanChart’s Lyons wrote in his 2012 outlook.
BofAML forecasts an average rate cut of 36 basis points among the major EM central banks that it tracks, as well as cuts to banks’ reserve requirement ratios and a relaxation of lending restrictions and capital controls aimed at preventing inflows. A likely exception to this projected easing in policy is central and eastern Europe, where negative output gaps and significant external financing requirements will likely constrain policymakers. In spite of the deepening crisis in the eurozone and the very real threat of deleveraging, Nomura therefore predicts that “the next moves by MPCs in the region will probably be hikes not cuts”. Most analysts also expect a continued adherence to spending cuts by all but the best-equipped nations in the region.
But while inflation fighting is likely to be put on the policy backburner in the early months of 2012, the memory of rapid capital inflows, commodity and asset price inflation triggered in the aftermath of the previous global downturn will remain fresh. Policymakers will also be conscious of the impact of prolonged near-zero interest rates and further rounds of quantitative easing and alternative liquidity-boosting measures in developed economies. Many analysts expect further liquidity boosts by the US Federal Reserve and the European Central Bank during the first half of 2011. This may re-ignite hot money inflows and re-stoke inflation pressures across emerging markets during the second half of the year.
As a result, emerging market policymakers will have to negotiate a tricky balancing act in the coming months, responding to the slowdown in the near-term whilst guarding against the risks of significant policy stimulus in the developed world and a return of capital inflows as the year progresses.
“Policy makers across emerging markets face a difficult set of choices ahead: respond to the slowdown via fiscal and monetary stimulus, or prepare for significant developed-market (DM) monetary stimulus and potential inflationary pressures,” Standard Chartered analyst Will Oswald wrote in a recent report. “We expect the former to dominate until end-Q1, but inflation risks are likely to re-emerge during the remainder of the year. This also raises the potential for a shift back towards macro-prudential measures, including stricter capital controls.”