What Lies Beneath
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Emerging Markets

What Lies Beneath

What the sell-off of Chinese stocks and subsequent market decline says about the world economy and Latin America


Barely a quiver had ruffled financial markets since May last year. So when they plunged in a wave of selling on February 27, their sudden and dramatic descent – the sharpest in the US since September 11, 2001 – caught many off guard. Investors rushed to unwind risky carry trades, scale back leveraged positions and cut exposure to assets with perceived stretch valuations, including emerging market stocks, bonds and currencies. Despite the enduring anxiety, global markets have since largely bounced back, with specialists expressing quiet confidence that the sell-offs were no more than a temporary correction.


In spite of the jolt to its markets, Latin America’s economic success story appears undiminished: “There has not been a material change to emerging markets or the Latin American economic outlook,” insists Tulio Vera, managing director and head of emerging markets macro and debt strategy at Merrill Lynch. The region is in its third year of economic recovery, with reasonable prospects for the year ahead. After reaching 4.8% in 2006, GDP growth is expected to slow to 4.5% this year, according to the Institute of International Finance (IIF), a Washington-based think-tank. Net private capital flows to the region eased back to $46 billion last year, from a record $71 billion in 2005, but should pick up slightly, says the institute. “The recovery in the region has been even sharper than after the Asian crisis, and IMF-supported programmes were not the only reason for this,” notes Anoop Singh, director of the IMF’s Western Hemisphere department.


Although the region may be more resilient to a reversal of fortunes – thanks to healthy fiscal surpluses, strong reserves and sound public spending – it’s not quite enough to banish the demons of decades of false starts. “Latin America is still more volatile and susceptible to what happened in the rest of the world than any other region in the world,” says Liliana Rojas Suarez, senior fellow at the Center for Global Development, and a former Deutsche Bank chief economist. “We can’t talk about Latin America without talking about the global economy. If we have a big shock abroad, clearly it will impact the region,” she says.


The nagging issue


The question remains whether a market decline could portend – or even bring about – an economic downturn, which would almost certainly drag Latin America with it. “The return to volatility is very much part of concerns over the US economy – obviously we could be in for a weaker 2007,” says IIF managing director Charles Dallara. It remains to be seen how emerging market economies, especially in Latin America, will fare if there is a significant slowing in US growth and further sell-off in commodities. “Any collapse of the dollar could exert recessionary pressure on the US economy – that’s a danger,” Dallara adds. Moreover, a sharp reduction in the US current account deficit could have a contractionary effect on the global economy. The global imbalances, in particular the persistently large US current account deficit and the large surpluses in Asia and oil-exporting economies, have been at the heart of the liquidity story in recent years, as the massive buying of US Treasury bonds has helped to depress long-term real interest rates. “The magnitude of global imbalances is contributing to excess liquidity,” says Jacques de Larosiere, adviser to the chairman of BNP Paribas and a former managing director of the IMF, who estimates that long-term rates would be 100bp higher without Treasury purchases from abroad.


A reduction in excess savings outside the US and a tightening of global interest rates – a trend which has already begun among G7 economies – could lead to a contraction of liquidity and a global recession. Harvard economics professor and former IMF chief economist Ken Rogoff maintains that there are two triggers for a severe global adjustment: a slowdown in US housing markets with the knock-on effect on consumer spending, and a sharp slowdown in the Chinese economy. On the first, there is a clear risk that the US slowdown could intensify in the months ahead. The end of the US property boom could urge households to tighten their belts at last, thereby ending the US role as the world’s biggest consumer before the world’s big savers start hitting the shops instead. Rogoff says it remains an open question what will happen if the global financial system is stress-tested by a US housing collapse combined with a sharp slowdown in China. A crash in the latter would lead to ripple effects in commodity producers like Brazil and Argentina, and oil producers like Venezuela would scarcely emerge unscathed. Malcolm Knight, general manager of the Bank of International Settlement also highlights the continuing risk associated with a sharp decline in the dollar and a rapid unwinding of global imbalances.“The question of what will happen and how it will work out really depends on how the savings/adjustment balance pans out,” he says. “Whatever happens, it’ll be accompanied by a weakening of global economic activity that will take a long time. That’s the problem.”


Complacency lingers


Financial markets themselves present further cause for alarm: even after the recent adjustments, the days of low volatility, easy money and ample liquidity seem far from over. Says Knight: “The tendency for markets to push things to the limit has not gone away. This could be an aspect of human nature. So, the risk of a globalized shock having a disruptive effect on the global financial system is still there and may have increased.” For Gerry Corrigan, managing director at Goldman Sachs and a former president of the Federal Reserve Bank of New York, risk is not being priced correctly: “Credit spreads across all asset classes are tighter today than arguably ever in history. The biases seem to be very much in the direction of risk being mispriced.”


Among the most acutely worrying risks is an unwinding of the yen carry trade, where investors who have largely ignored risks in recent years have been leveraging their bets globally by borrowing Japanese yen – a move that costs them next to nothing in interest – and investing the proceeds in an assortment of higher-yielding assets. If investors continue to unwind their positions, as they did for a time in March, the knock-on effects on risk taking could be severe and would lead to a repricing of risk across the board. “The statistical probabilities of major financial shocks may be lower, but the corollary to that argument is that the potential damage those shocks can make is a hell of a lot greater,” says Corrigan. “The central issue is evaluating probabilities and damage.”


The return of volatility this March also brought home once again the potential for contagion, especially when markets move violently. “There may be interconnectedness we had not anticipated,” says Dallara. Leverage is the big risk, says Philip Poole, head of emerging markets research at HSBC. “The withdrawal of leverage can cause contagion. That’s the risk.” Corrigan also points to the world of “today’s leveraged buyouts” as the highest systemic risk facing markets today. “There’s no question that [global financial integration] can bring with it unintended consequences – accompanied by, driven by the complexity and speed of the financial markets,” he says. “If you have any material slowdown in economic activity, those margins are going to come down fast,” he says, though he admits that trying to assess leverage in today’s financial system is “nigh on impossible”. “Our collective capacity to anticipate such shocks (timing and trigger) is virtually nil,” he adds. “If we could anticipate them, they’d not happen. So we have no choice but to focus our attention and resources on shock absorbers of the global financial system.”


Risk ahead


The vagaries of the market, together with the looming economic storm clouds, says Dallara, are a “wake-up call” to deepen the reform process and “reduce vulnerabilities” to financial shocks. But he argues that reform in Latin America has not gone deep enough: “Leaders are missing a wonderful opportunity to reform,” he says. “The standards of transparency, of auditing and disclosure that investors are used to are just not there in emerging markets. It’ll take some time until local equity markets, for instance, get up to speed.” Countries need to have robust adjustment mechanisms to be prepared for shocks,” says the IMF’s Singh. “There will be corrections.”


The region is still greatly exposed to US weakness, which could impact commodity prices and throw into sharp relief the evolution of Latin economies into more mature, sophisticated markets. The IMF estimates that the substantial run-up in the international commodity prices since 2002 has boosted these countries’ export earnings by more than a cumulative 20% of their GDP. The Fund, however, recently looked into what would happen to the largest seven countries if commodity prices dropped. “You find that the primary fiscal balance across the region would clearly decline, but under most reasonable assumptions they would still remain in surplus,” says Singh. For example, if commodity revenues fell to their 2004 levels in these countries, primary surpluses would fall to around 2% of GDP, he notes.

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