Emerging Markets: Emerging Questions
August 28, 2007
By Gray Newman and Luis Arcentales | New York
As the US sub-prime turmoil morphed first into a problem for a few prominent hedge funds and then into a broader freezing up of credit markets, emerging markets held up relatively well. Indeed, after a few days of nervousness this month, once again I have begun hearing talk that emerging markets are the new ‘safe haven’. And while it is hard to find an emerging markets practitioner that doesn’t apologize for stating that ‘it’s different this time’, there are plenty that seem willing to argue just that.
The advocates of emerging markets as a ‘safe haven’ have marshalled some powerful evidence. After all, unlike the turmoil of 1998, this time the problem did not start with emerging markets and more importantly many emerging markets have much stronger balance sheets than they did in 1998. As our GEMs equity strategist Jonathan Garner likes to point out, in the summer of 1998 it was poor emerging market fundamentals leading the charge on contagion, while today it is the mirror image with poor fundamentals starting in the US (see “Strong Decoupling and the Mirror Image of 1998”, GEM Equity Strategy Weekly, August 23, 2007).The poster child for the ‘safe haven’ camp might be Brazil. After all, here is an economy that epitomized all of the risks of emerging markets just a little over four years ago when investors were worried that it was on the brink of default and capital controls. Today, Brazil has international reserves covering two times the entire gross public external debt stock. Indeed, we calculate that before the year is out, Brazil is likely to have enough reserves to cover all public and private external obligations. That’s right, reserves should soon cover not only syndicated loans to the sovereign and all outstanding sovereign bond issues, but every inter-company loan and other external obligation of the private sector. In addition, a significant improvement in Brazil’s debt profile makes it less sensitive to market turbulence. It is perhaps no wonder then that Brazil’s external debt sell-off has been modest, its stock market is still up for the year despite the recent turbulence and its currency is once again trying to break through 2.0 — a level that just a few months ago many thought would be tough to break. And it’s little surprise that our Brazil economist, Marcelo Carvalho expects to see Brazil’s sovereign rating reach investment grade by mid-2008. With the move by Moody’s last week, now all three major rating agencies — Moody’s, Standard & Poor’s and Fitch — have rated Brazil’s external debt just one notch below investment grade. Of course, Brazil is hardly the only case of the remarkable turnaround in emerging markets. Russia dwarfs Brazil whether reserves are measured in dollar terms or as a percentage of total outstanding public and private external debt. And China, in turn, with over US$1.3 trillion in official currency reserves dwarfs Russia. Indeed, the abundance enjoyed by emerging markets in recent years has led to the emergence of a new powerful force in financial markets, the sovereign wealth funds that our currency economist Stephen Jen has been tracking carefully. Hotel California My cautiousness when confronted with the arguments of the ‘safe haven’ camp stems from four concerns: First, the emerging market boosters and the ‘safe haven’ arguments have emerged in a world that is now in its fifth year of above-trend global growth. We simply haven’t seen a string of this many good years of global growth since the early 1970s. That coincidence should sound the warning bells. I am a bit sceptical just how many believers in the ‘safe haven’ thesis will remain if we have a patch of below-trend growth. After all, what has contributed to the abundance in current account surpluses, fiscal surpluses and massive reserve accumulation has been a remarkable bout of above-trend growth with particular emphasis on demand for commodities found in many emerging economies. It may indeed be true that emerging economies will ultimately prove more resilient — I certainly suspect that their growth track records will continue to beat that of the developed world — but that doesn’t mean that they are immune from the global business cycle. Yes, it is true that the trio of massive reserve accumulation, current account surpluses and fiscal surpluses means that these are not the emerging markets of yesteryear. And yes, starting points do matter: if the globe is heading for a soft patch and credit will be less plentiful, having large reserves makes a difference, as do surpluses on the fiscal and current account front. But that is unlikely to provide any immunity to business cycles. The promise of progress in emerging markets is that this time around they might slow if the globe slows, rather than experience the nasty financial meltdowns for which they are famous. Second, I am sceptical of the ‘decoupling’ thesis. Before we ring in the decoupling era, it is worth recalling that it has not been tested with a US economy in recession. Our US economists Dick Berner and Dave Greenlaw are not calling for a US recession, but they do warn of more softening to come (see “After the Shock: Risks for the Global Economy and Markets”, Global Economic Forum, August 20, 2007). I am wary of extrapolating from the current global environment in which the US economy is still growing over 2%. If the US economy, led by the US consumer, were to suffer a sharper downturn, then I’m concerned that the linkages from the US to commodity prices and demand and the favorable terms of trade shock that most of the emerging markets has enjoyed could be called into question. Third, there are still plenty of vulnerable economies in the EM space. For every story of improvement, the emerging markets are still littered with vulnerable credits. For every emerging market with a current account surplus, there appears to be another with a looming deficit. Russia and Brazil may be darlings on the balance of payments side, as well as Venezuela and the Philippines, but then there is India, South Africa, Turkey and Hungary with worrisome imbalances precisely at a time when global liquidity is being questioned. On the fiscal front, the vulnerabilities appear to be greater still. While Russia and Chile get high marks for sizable fiscal surpluses, for every major emerging market with a budget surplus there are appear to be two with a burgeoning fiscal deficit. Turkey, Poland, Hungary and India have all been running fiscal shortfalls ranging from 3 to 8 percentage points of GDP in the last three years. And while the precise links between strong global demand, a robust terms of trade and the fiscal performance of each of the emerging economies varies, there can be no denying the importance that commodities have played in many emerging economies. Among the major emerging economies, it is commonplace for commodities to represent more than half of all exports, and those commodity exports can easily account for 10, 20 or 30 percentage points of GDP. Venezuela tops our list with commodity exports — essentially oil — reaching the equivalent of nearly 40 percentage points of GDP. Of course, some countries such as Chile have engaged in counter-cyclical fiscal policy, which should help to cushion the decline if copper prices were to soften. Others such as Turkey, as Serhan Cevik has pointed out, would benefit from a decline in oil prices, given Turkey’s position as a net importer of oil and oil derivatives (see “Debating Recession Risks”, Global Economics Forum, September 15, 2006). Fourth, while abundance has brought stability and good growth to emerging economies, it has also brought widespread complacency among policy makers. That may be inevitable. And, indeed, it is hard to drum up too much concern over the level of gridlock that often plagues the political process in the emerging economies; after all, the developed world is used to seeing it at home. There is an important difference, however, that makes the failure of progress in the emerging economies much more worrisome: the shortfalls in human capital, the often limited funding for infrastructure and public investment, the inadequacies in the regulatory environment to promote competition and the wide disparities in assets and income mean that in downturns the ‘safety net’ is often frayed at best. Prolonged downturns can easily set off political and social turmoil. Bottom line After five years of above-trend global growth, it seems as if everyone I speak with is a believer in emerging markets. And that worries me. The economic starting point of many of the emerging economies does indeed appear to be different today. The number of over-extended economies — whether in the form of fiscal deficits or excessive current account imbalances — is lower today than I have seen in many years. Some economies prone to accidents in the past are likely to come through a period of global softness without a major meltdown. But I suspect that many believers in the ‘safe haven’ thesis could find their confidence called into question if the US slowdown morphs into a patch of below-trend global growth as risk gets repriced. The emerging market diehards might be proven to be ultimately right, but I suspect that their numbers would be greatly diminished.
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When Other People’s Bubbles Burst
August 28, 2007
By Serhan Cevik | from Istanbul
Consumer price inflation will increase in the next couple of months. We started the year with a series of disappointing data, as the surge in unprocessed food price inflation from 12.9% at the end of 2006 to 20.7% in January pushed the headline figure higher. However, the lagged effects of monetary tightening on domestic demand and the gradual correction in food prices have helped to bring inflation dynamics towards a more favourable trajectory. As a result, consumer price inflation eased from 10.9% in March to 8.6% in June and 6.9% last month. This is the lowest reading in the past four decades and confirms the secular nature of disinflation in Turkey. According to our projections, the annual rate of change in the consumer price index will decline to 6.2% by the end of this year and then below 4% in the second quarter of next year. Nevertheless, this is not going to be a linear process, and we are likely to experience setbacks every once in a while. Indeed, we expect the year-on-year inflation rate to increase to 7.5% in August and show no material improvement next month. The main factors behind this pause in disinflation are base effects and the behaviour of food prices (see Heat Wave, June 20, 2007). There is also the risk emerging from higher volatility in global markets. It is not a secret that inflation — and therefore the monetary policy stance — is susceptible to change in global risk appetite through its effect on the exchange rate. The burst of the credit bubble is a threat, but the lira stands on stronger footings. What a ride we had — from the ocean of liquidity to the desert of uncertainty, as the unwinding of the credit cycle has undermined confidence and led to the sudden withdrawal of market liquidity. Aftershocks of the financial turmoil eased in recent days, but there is still a dichotomy in markets about the future direction of the global economy. For the time being, real economic fundamentals stand strong against a hard-landing scenario. However, even though we have no doubt about structural improvements (especially in emerging economies), the global economy is vulnerable to financial turbulence and a major downturn in the US business cycle. After all, expansionary financial conditions in the last six years had an overwhelming effect on economic activity across the world. Therefore, even if we assume the resilience of structural gains, tighter financial conditions would still have an adverse effect on the real economy. Furthermore, a broader repricing of risks implies a possible contraction in cross-border capital movements that could put pressure on emerging market currencies. In Turkey’s case, for example, the exposure to liquidity-driven capital flows represents the most critical vulnerability (see Shockwaves and the King of Carry Trades, August 15, 2007). Nevertheless, having such a ‘weak spot’ does not necessarily mean that there are no cushions to safeguard the economy against exogenous changes in global risk appetite. First, economic fundamentals are now far stronger than at any other time in recent history. Second, the banking sector is robust and liquid enough to provide funding to the troubled European banks. Third, residents accumulated more than US$30 billion in foreign currency-denominated deposits over the last year, which now stands at US$90 billion against foreign investors’ US$32 billion in domestic government debt. The credit squeeze may have disinflationary effects, but the drought is a serious challenge. The effects of financial turbulence on the global economy may well turn out to be disinflationary, with slower demand and a correction in commodity prices. Of course, the credit squeeze would also moderate bank lending and the recovery in domestic demand in Turkey. The credit channel has become more important for inflation dynamics, as the number of credit users increased from 15.8 million in 2002 to 30.7 million last year. As a result, household debt grew from 4.7% of disposable income to 25.2% over this period, making domestic demand sensitive to changes in financial conditions. This is why we have argued that the lagged effects of monetary tightening become more pronounced on consumer spending and the behaviour of inflation. Indeed, a closer look reveals that there has been a sharp slowdown in private consumption (especially of durable goods that are sensitive to interest rates). In our view, all these real factors have helped in lowering durable goods inflation (excluding gold) from 3.1% at the start of the year to -2.2% in July. Even the infamously sticky non-tradable inflation eased from 12.2% to 10.2%, contributing to the drop in the seasonally adjusted annualized inflation rate from 12.8% just a few months ago to 2.4% on the last reading. We expect monetary easing to be gradual and measured over the next year. There are some signs of stabilization in global financial markets, but it just too early to call the end of the turmoil. We still do not know the extent of the problems, and the credit squeeze may lead to a deeper-than-expected correction in economic activity. As a result, countries like Turkey will remain susceptible to further volatility in risk-taking and exchange rates. Furthermore, election economics — non-interest spending rising by more than 25% in the first half — and the volatility in food prices continue to challenge the central bank’s efforts to bring inflation in line with the target. Therefore, even though secular developments have improved the quality of disinflation, we still expect monetary easing to be gradual and measured over the next year.
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New Defensive Korea
August 28, 2007
By Sharon Lam | Hong Kong
The Korean economy has often been perceived as volatile, which made it vulnerable to any shocks in the global economy. It is also commonly taken as a tech- and export-oriented economy that could be hit hard by any deterioration in US demand. During a downturn, Korea used to correct quickly and sharply. The US sub-prime woes are again casting doubts on the sustainability of Korea’s economic recovery. The most
asked question is whether Korea can decouple from the US or even global demand. We do not believe in decoupling. After all, it is still undeniable that US demand remains one of the world’s growth engines. If the US slows, Korea’s export growth will be affected, but this is not just a Korea story, rather it is a regional one. In such an environment, investors should look at the more defensive economies; we believe Korea is one. A defensive Korea could be a rather new phenomenon to many, but we should adjust to this new view. Korea has changed a lot after the financial and credit card crises, and it should not be regarded as a vulnerable economy anymore, in our view. The biggest threat to Korea is not a US slowdown, but rather a China slowdown or too-high interest rates in Korea itself. The risk of a near-term China slowdown is low, and we also remain particularly constructive over China’s domestic demand growth over the medium term. Our biggest worry has been too much monetary tightening in Korea by the central bank, but such risk is also significantly subsiding. Therefore, we believe that there is no need to panic over Korea’s fundamentals. We argue that Korea is more defensive in terms of the following: 1) diversified export profile; 2) domestic growth discipline; and 3) room for stimulus. Diversified export profile Korea has a much more diversified export profile than what is commonly perceived as for a tech-oriented economy. Other than tech products, such as semiconductors, computers, mobile phones and LCDs, non-tech products are also pillar export industries in Korea; these include automobiles, ships, industrial machinery, chemicals, metals and petroleum products. Therefore, Korea is much less susceptible to any one particular product cycle. For example, despite softer tech exports in the past 12-18 months, Korea was still able to maintain robust overall export growth because of strong orders for ships, chemicals and metals. Meanwhile, Korea’s direct exposure to US demand is also diminishing, as the US is now only Korea’s third-largest export market, after China and the EU. Apart from China, which obviously benefited from production relocation, Korea is the only country in the region for which the export share to the EU has risen in the past decade, implying a more successful new market expansion than for other regional economies. This development alone is not sufficient to argue that Korea is getting less sensitive to the US, as a similar phenomenon is happening to all countries in the region. However, Korea differs from other countries in the region (except Japan) in that it not only uses China as a re-export base, but has been supplying China’s domestic demand as well. We estimate that parts and components that are to be reassembled and shipped to other destinations, such as the US and Europe, take up roughly 30% of Korea’s exports to China and that the rest are products for production and construction purposes in China, with major items being machinery, metals and chemicals. Korea’s exports of machinery are well correlated with China’s loan growth and fixed asset investment, implying that Korea’s exports are sensitive to domestic growth in China. Korea’s export growth has stayed robust in the past 12 months from strong China demand, despite moderation in US demand. Meanwhile, Korean brands have done an extraordinary job of penetrating China’s consumer market in the past few years. Korean-made automobiles, mobile phones and household electronics are all popular in China. China is also the largest export market for Korean-made cosmetics, furniture and footwear. Indeed, Korea has emerged as China’s second-largest import source after Japan, a huge achievement for Korea considering the difference between the two economies’ sizes. We are confident that China’s government will continue to strive for buoyant consumption as part of its economic restructuring plan. As a result, Korea’s exports will still be partly supported by Chinese consumption, even if demand from the rest of the world falters. This is a cushion that Korea can enjoy over most other countries in the region. Disciplined investment and consumption help avoid any sharp correction Korea’s economy used to be volatile because domestic demand surged together with exports, resulting in strong economic growth and sentiment, which often created excesses that needed to be adjusted significantly during downturns. Having learned from the over-investment-led financial crisis and over-consumption-led credit card crisis, Koreans have become more disciplined in managing their domestic demand and, to a certain extent, have been too conservative in their spending. This partly explains why the export boom since 2004 has not translated to equivalent strength in domestic demand. There has been capex growth since 2006, but it was coming from a low base to catch up with the need in capacity expansion to meet demand growth. Nevertheless, even after almost two years of capex growth, Korea’s capex-to-GDP ratio is still lingering at a 20-year low of 29%, implying that the capex addition in the past two years has not resulted in any overcapacity. In fact, capacity utilisation is still hovering above 80%, meaning that downside to capex is already limited. Without an investment overhang, there should not be any major correction in the economy, even if the external environment turns hostile. The same story applies to consumption. Household spending has been underperforming wealth gains from both stock and property markets in this cycle. An ageing population, which is causing households to reinvest their capital gains rather than to spend, and a rising interest rate and tax burden, which is capping sentiment and purchasing power, are the main factors limiting consumption growth. There is no doubt that overspending is absent in this cycle. Therefore, again, there should be no correction. More room for stimulus than in other countries Korea is the only country in the region that has had consecutive years of fiscal surpluses since 2000, and we expect the surpluses to continue at least until 2010. Korea’s fiscal policy has indeed been less counter-cyclical than it should have been under the government’s cautious spending. Yet this fiscal discipline pays off to maintain a solid sovereign rating, despite North Korea’s nuclear threat, and also to give Korea more room for stimulus during unexpected crises. The question is, how much can Korea spend fiscally? The region’s average fiscal balance in the past five years was -2% of GDP, and we believe that Korea running a temporary deficit smaller than that should cause no concern about its sovereign rating. We estimate that Korea will have a fiscal surplus of 0.5% of GDP, if the government sticks to the same conservative expenditure and revenue policy. But, if supportive measures are needed and the government chooses to run a fiscal deficit at 2% of GDP, a total of 2.5% of GDP (2% deficit plus reversing the surplus of 0.5%) of extra stimulus would be injected in 2008 compared with in 2007. What kind of fiscal stimuli can Korea generate? The most direct ones are income tax cuts and capex (either facility investment or construction). The effect from tax cuts would be smaller than that from capex, as the propensity to consume has been declining as a result of the ageing population. We estimate that a fiscal stimulus of 2.5% of GDP in 2008 would boost Korea’s GDP growth by 0.5-1.3ppt (with the maximum to be achieved through spending all on capex). On the other hand, we estimate that a 10% decline in exports to the US would cut Korea's GDP 0.4 ppt. Exports to the US dropped 17% during the 2001 US recession. Assuming a similar magnitude of decline this time would mean less than a 0.8ppt cut in Korea’s GDP. This means a mere 2.5% of fiscal stimulus could partly, or even more than, offset the decline in export growth. Most importantly, we think that Korea does have the capacity to run a temporary deficit to boost the economy next year. Aside from the fiscal front, Korea also has more room for monetary stimulus, as its interest rate level is already higher than neutral, in our view. Its real interest rate level is the second-highest in the region after that in Hong Kong. The Bank of Korea (BoK) has been hawkish towards too much liquidity in the economy and the subsequent asset price increase, and acted with its latest rate hike in August. This pushed the overnight call rate target to 5%, while we estimate that the neutral rate should be 4.8%. Already we believe that the last rate hike came at a bad time. Now, given this belief, together with global fear of a credit crunch, uncertainty in external growth, and investors flirting with the idea of early Federal Reserve rate cuts, we believe that the BoK will turn much less hawkish. We expect the BoK to keep rates unchanged at least in the next six months, yet we still do not rule out the chance of more rate hikes if the property market is revived after the presidential election. In fact, with ample liquidity in the economy, investors may once again turn to the property market as external uncertainties now cloud the equity market. A rate cut from the BoK still looks remote, in our view, unless external conditions turn much more hostile than we expect — that is, there is a hard-landing in the US and China’s economy also slows. Nevertheless, if monetary easing is required, we think that Korea has room for more rate cuts than most other countries in the region. Don’t rush to tone down growth expectations A complete decoupling from the US economy is not possible, in our view, but we urge investors to rethink Korea’s changing fundamentals and believe that it can actually emerge as a defensive economy in times of external crises. Korea does not have any domestic excesses that need to be adjusted; this factor largely reduces the magnitude of any potential external-led slowdown. Meanwhile, Korea’s exposure to the US is diminishing and China demand will serve as a cushion that Korea can enjoy over other countries in the Asia ex-Japan region, as a result of the success of marketing Korean brands to China consumers. If the external environment were really to turn sour, Korea would have ample room for fiscal and monetary stimuli. Also, a new government in 2008, if coupled with stimulative policies — such as relaxing housing policies or adopting fiscal deficits — could boost the domestic economy. Korea’s exports cannot decouple from a US slowdown, but we believe that domestic demand can decouple from exports in 2008. Korea does not deserve too much pessimism, in our view. Many are rushing to tone down their growth expectations for Korea next year; even the government has commented that the economy may peak earlier than expected. However, we are sticking to our view that the Korean economy will have more upside in 2008. We are not worried about the effect of a US slowdown on Korea; what we have been warning about is too-high interest rates in Korea (see Rate Hikes Delaying Consumption Recovery to 2008, August 9, 2007), but recent developments have largely cut the risk of another rate hike in the near term. Meanwhile, we are getting a clearer picture of the presidential candidates and their policy agendas as we approach the presidential election in December, which will gradually help revive sentiment, in our view. Weaker headline growth in 2H07 is highly likely, but we expect momentum to pick up again at the beginning of 2008.
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