By Jack Boorman
How today’s global financial crisis will impact emerging market economies
The potential spillover to emerging market economies from the ongoing crisis in the major financial markets has been a threat hanging over those countries for the past year. First, the spillover could come through the turmoil in the financial system itself, where major financial institutions are facing unprecedented losses and where credit markets have been severely disrupted; and second, through the impact of the crisis on the real economy evident in the slowdown in the United States and Europe and, increasingly, elsewhere in the industrial world.
These spillover effects present significant policy challenges, but also opportunities, for the emerging market economies. The challenges are further complicated by the volatility in food and commodity prices, including crude oil, and the significant uptick in inflation more generally. The inflation threat, including that from earlier monetary easing in a number of countries, has become pervasive across emerging market countries, and is particularly acute in Asia. However, the appropriate response to that threat now depends on near-term prospects for global economic activity and commodity prices, and the way in which those prospects impact individual emerging market economies.
Policy making in emerging market countries also needs to take account of the increasingly complex – and diverse – interlinkages between those economies and the industrial countries. These links have often been cast primarily in terms of the export and, therefore, the growth dependency of emerging market countries on the pace of activity and the stance of monetary policy in the industrial world.
In recent years, there has been some debate about the extent of this dependency and whether, given the increasing size and sophistication of the emerging market economies and the increasing interlinkages among those countries themselves, some “decoupling” had occurred between emerging market countries and the industrial countries.
But there appear to be fewer and fewer analysts willing to argue that a significant decoupling has occurred. In fact, in addition to the familiar relationships, new and more complex ways have developed in which emerging market countries and industrial countries are connected. In this broader view, rather than a decoupling, increased ties have emerged that complicate the interactions among these groups of countries.
Direct impacts
Until recent weeks, the most direct impact of the crisis on emerging market economies and their financial systems appears to have been limited and less than what some had feared. Banks and other financial institutions in those countries appear to have had only limited exposure to the securitized instruments and special investment vehicles at the heart of the original disruption. The repeated surprises seen in financial institutions in Europe, for example, have been mostly absent in emerging economies. At the same time, however, because of a lack of transparency in some countries, and in light of the recent significant increase in the intensity of the crisis, it is impossible to know whether some financial institutions may still be vulnerable.
But these are only the direct effects on the balance sheets of financial institutions in the emerging market countries. There is still the potential for less direct effects of the crisis to be seen in those countries. Until quite recently, the improved fundamentals, large accumulations of reserves, and rapid growth in emerging market countries all helped to sustain inward capital flows. But the risks to such flows have been growing in recent months. The major global banks whose balance sheets have been severely weakened may further pare back funding to their local subsidiaries in the emerging market countries. Moreover, the general contraction of the balance sheets of the major institutions and the need to rebuild their capital base is constraining the funding available to other institutions in both the industrial countries (e.g. hedge funds) and in the emerging world that rely on dollar (or even Euro) funding.
Either of these developments could produce additional financial stress in some emerging economies – especially in Central and Eastern Europe – that have run up dangerously large current account deficits and taken on substantial international debt. Moreover, while the crisis continues to unfold – and to surprise - most of the risks continue to appear to be on the downside, even threatening some of the better performing emerging economies. Indirect impacts
The second channel through which the ongoing crisis could impact emerging market economies, i.e., a slowdown of economic activity in the industrial world, is becoming increasingly evident with each revision of growth projections for the global economy. (Figure 1) The United States are pivotal to global prospects, and within the US economy, spending by consumers, which accounts for about 70% of the economy, remains key.
But by all appearances, the US consumer is topped out on spending and on debt and is unlikely to be a source of strength in the economy. Consumer credit is at unprecedented levels; spreads on securities backed by consumer credit have risen sharply and delinquencies are expected to rise further; mortgage foreclosures are at extremely high levels – and still rising – in many regions of the country; consumers’ equity in their homes continues to decline dramatically; and the wealth transfers to oil exporters and commodity producers from still high prices come ultimately from consumer budgets.
Amidst all this, and not surprisingly, consumer confidence in the United States has fallen sharply. Thus, there seems to be little prospect that a recovery in the United States will start with the American consumer.
Other sectors of the US economy appear unlikely to be able to offset weak consumer spending. The large structural deficit in the federal government’s accounts and the huge fiscal burden taken on in the rescue packages for the financial sector reduce the scope for fiscal stimulus in the United States. While the automatic stabilizers should be permitted to operate, there may be only limited scope for any substantive stimulus beyond that. The sharp increase in the financing needs of the US government raises troubling questions about the continued willingness of the rest of the world to provide the necessary resources on the terms available to the government in recent years. The steadily deteriorating budgets of state and local governments suggest that there will be retrenchment in that sector as well.
While US exports have done well recently, these account for a relatively small share of the overall economy and are dependent on the strength of other markets which are, in turn, partly dependant on the United States itself. The recent strengthening of the US dollar – if it persists in the face of the unprecedented financing needs of the government – raises further questions about the continued buoyancy of exports.
Growth prospects in Europe look equally weak if not worse, and the focus of the European Central Bank on its legally imposed single objective of reducing inflation limits its policy options to help counter the evident slowdown. In short, the prospects for a near-term recovery in the mature economies appear weak and the softening of economic activity that was already evident is likely to continue or to worsen. Perhaps spending by the oil exporters will help bolster global demand, but they are now facing inflationary threats and declining revenues that require restraint in many of those economies.
Decoupling, recoupling
The impact of the softening of activity in the industrial world on the emerging market economies is less clear. Recession, or even slow growth, in the mature economies will undoubtedly reduce growth in many of emerging market countries. While this may not necessarily be of major concern given the recent overheating in many of them, a more significant slowdown in the emerging world – which now seems unavoidable - could feed back to and aggravate the weakening of activity in the industrial world. The extent of the impact of the slowdown or recession in the industrial economies on emerging market economies depends on the extent to which decoupling has occurred and on the capacity, and scope, for emerging economies to offset that impact through their own domestic stimulus policies.
The evidence is growing that decoupling has not occurred to anything like the extent that would be needed to isolate emerging economies, and the developing world more generally, from a weakening of activity in the industrial world. Some of the original arguments about decoupling rested on the ever-increasing trade among emerging market economies. But much of this trade reflected the fundamental shift that was occurring in the locus of manufacturing – the supply chain – in the global economy. Much of that trade among emerging market economies – and, indeed, even between the industrial and emerging market economies – reflected the specialization of manufacturing in different countries on inputs and components that were then shipped elsewhere for further processing and assembly before shipment to the final user. In many ways, this led to an increase in the coupling between economies rather than a reduction.
Perhaps even more importantly, beyond trade, other significant interlinkages that have developed now increase the dependency among various groups of countries and reverse the direction of influence. For example, for years it was the developing world and emerging market countries, in particular, that were dependent for their financing on the global financial markets centered in the industrial countries. Large current-account deficits in the emerging market countries were financed through capital flows from the industrial world. Much of that financing took the form of bank loans until the mid 1980s and then became increasingly dependent on the bond markets.
That story ended in the financial crises in Latin America in the 1980s, and in Asia and elsewhere in the 1990s and the first few years of this millennium. Important lessons were learned in those crises and many of the emerging market countries fundamentally changed the management of their economies. Macroeconomic policies became more orthodox, policy-making institutions were strengthened and the flow of capital shifted dramatically. Together with the rise in crude oil and other commodity prices (Figure 2), the rapid growth of emerging markets with high savings rates, and the shift in the United States to negative savings by both the government and consumers, fundamentally changed the nature and the flow of capital – and dependency – among the world’s economies.
The increase in commodity prices themselves was further evidence of the shift in influence that was taking place. It was the rapid growth of many of the emerging market countries themselves that led to the sharp rise in commodity and raw material prices. That development, in turn, became the dominant influence on inflationary pressures in the industrial world, limiting the power of traditional central bank policy instruments to control domestic inflation.
Thus, the interlinkages between the industrial and emerging world have become far more complex and multi-dimensional, and the very concept of decoupling seems almost quaint. The framework of analysis can no longer be limited to the impact of the level of activity in the industrial world on the emerging market economies. As important is the influence of high savings rates and capital flows from the emerging economies to the industrial world, and especially the US.
Rather than a decoupling, therefore, an increased inter-dependence has emerged. Policy in the industrial countries needs to anticipate the impact of growth in the emerging world – through the effects on commodity prices, for example –, as well as the impact of changing savings rates and portfolio investment preferences on interest rates and exchange rates. In turn, policy in emerging market countries needs to anticipate the impact of changing levels of activity in the industrial world on exports and on foreign direct investment.
Jack Boorman is a Member of the Advisory Board of the Emerging Markets Forum; Former Director of the Policy Development and Review Department, and Former Counselor and Special Advisor to the Managing Director, International Monetary Fund.