Financial markets are the gate-keepers on capital flows to emerging economies, but their views can be disruptively fickle. Earlier this year the 'search for yield' brought a flood of foreign capital to these countries, supported by effusive commentary from the international press and market economists. Emerging economies were seen as the driving force of global growth.
Now there has been a change of heart. Gloom-laden commentary is typical and emerging economies have lost their starring role in the world growth narrative. A couple of examples: 'From a tumbling currency to a crippling current-account shortfall, slowing economic growth, high inflation and retreating investors, Indonesia's stature as emerging-market superstar is under siege.' And: 'The Indian economy stands at the threshold of an outright foreign exchange crisis'.
To understand this abrupt U-turn in opinion, we need to note that the focus of financial markets has been self-referential — based on their own actions and portfolios. When US Fed Chairman Ben Bernanke hinted in May that quantitative easing (QE) would taper at some stage, short-term investment flows reversed direction. As these funds departed they pushed exchange rates, local equity markets and domestic bond prices down sharply. As a result, foreigners' portfolios took a hit, and the stark commentary may reflect this personal pain. No analysis was complete without a reference to the 1997 Asian crisis, with speculation of an imminent recurrence.
We need to separate the impact of this capital reversal from the underlying economic health of the various emerging economies. [fold]
First, how detrimental is the capital reversal? Of course the volatility of short-term capital flows is disruptive (and serves as a reminder of the limited usefulness of such capricious inflows). It is also a legitimate cause of complaint that emerging countries have been caught in the backwash of aberrant policy settings in advanced countries.
How much damage will be done by the reversals? The sharp falls in exchange rates (India has fallen 16% since May while Indonesia, Brazil and Turkey have all fallen by more than 10%) will push up inflation, but these lower exchange rates will boost international competitiveness.
The reversal in flows is a painful inconvenience rather than a foretaste of disaster. None of these countries has a high level of external debt, all have flexible exchange rates and all have adequate foreign reserves. The reversals are confined to portfolio and banking flows. Foreign direct investment (the longer-term component with its valuable technological transfer) seems largely unaffected. During the 2008 meltdown in advanced financial markets, FDI continued to flow unabated to the emerging economies (see Figure 4 here). The current experience seems the same.
Second, even if the unsettling reversals reflect external events rather than a well-founded reappraisal of emerging economies, we still need to check whether there are deeper internal problems which are likely to derail the world recovery.
Current account deficits in both Indonesia and India have been increasing in recent years, but this is not in itself cause for alarm. It would be a concern only if the deficit is unsustainable. (The rationale for overseas borrowing is to allow a country to increase its imports; the current account deficit is merely a measure of how much more a country is importing than it is exporting.)
Growth has slowed in both India and Indonesia, but is still over 4% in India and just under 6% in Indonesia. Elsewhere, some are doing a bit better than forecast (Mexico) and some worse (Brazil). The big one, China, is still recording the same 7%-plus growth, just a touch below the average for the past couple of years, despite the persistent drum-beat commentary that the economy is slowing, perhaps sharply.
There is no disagreement that each of the emerging countries faces daunting policy challenges and each has room to do much better. Budget deficits are often an issue, as in India. Structural reform is no more politically palatable in emerging countries than it is in advanced economies. Among the disparate group, some will do badly.
It's also true that aggregate emerging-economy growth is now significantly slower than in 2010, as the IMF reported to the G20. But this slowing occurred in 2011; for the past two years emerging countries have been growing consistently a bit above 5%, and the Fund's July forecasts showed some acceleration next year.
Despite the deadweight cost of corruption, debilitating inefficiency and inadequate infrastructure, the emerging economies in aggregate are still growing at twice the pace of the best performers among the advanced countries. The 5%-plus growth they have recorded over the past couple of years accounts for half the world's growth. The heft of emerging economies in world GDP has increased, so if they maintain their recent growth rates, their contribution to world growth is increasing. We'll have to wait to see if the Fund's forthcoming October forecasts incorporate the same downbeat view Managing Director Christine Lagard put to the G20 meeting: 'Just as some advanced economies have begun to gather momentum, many emerging markets are slowing'.
Photo by Flickr user mag3737.