Emerging Markets: Gimme Shelter

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Marcus Wright RBS Economics November 2015 Emerging Markets: Gimme Shelter

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What’s this about? Growth in emerging markets is slowing. This is concerning. We consider two key questions: 1. What are the problems in emerging market economies? 2. Why does that matter to us?

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Emerging markets matter more than ever Emerging markets have accounted for 50%-60% of global output & 70% of global economic growth each year since the crisis. They are much more important to the global economy compared with the late 1990s when the last EM crisis struck. In other words, an EM slowdown can do a lot of damage to the outlook for global growth.

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Pass the credit parcel While credit growth stagnated in developed economies following the crisis, it rebounded quickly in emerging markets. But now slower EM credit growth and Eurozone deleveraging has left global credit growth in the doldrums.

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Quelle surprise – China is the main culprit Credit to China’s non-financial private sector has risen a staggering $15trn since the crisis – close to the size of the US economy. China’s credit pile has risen from a mere 20% of the level of the US to 80% in just six years. When credit rises that much so quickly, much of it inevitably gets wasted.

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A reckoning awaits China’s banking sector It’s the corporate sector that has driven China’s debt increase. Hong Kong’s build-up has been even greater, relative to the size of its economy. China’s banking sector is likely to be sitting on non-performing loans in excess of official figures. China can afford the clean-up but the debt overhang and banking sector repair will drag on growth.

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That debt is becoming more of a burden Emerging economies have gorged on debt. Consequently, since the crisis, they are devoting more of their incomes to repaying it. Developed countries by contrast are devoting less. Despite China’s relatively closed financial system, global banking exposure to China is $1.5trn.

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A big score…off-shore Offshore bond issuance results in the classic emerging market problem – currency mismatch on the balance sheet of EM firms. A move toward tighter US monetary policy could expose these vulnerabilities. Unsurprisingly, China is again the major player with real estate, finance and oil & gas the main sectors.

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The problems are more than debt alone Having previously grown much faster than the pace of global GDP growth, world trade growth is now slower. Emerging markets hoped for a strong rebound in export growth following the crisis but it never materialised. It’s not just due to the Eurozone. China’s slowdown is transmitting across other emerging markets as reduced demand for their exports.

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Here comes the deflationary wind Emerging markets pushed investment in productive capacity, housing & infrastructure in response to the global slowdown. The global economy benefitted because developed economies pulled back. Too much investment. Too much capacity. Lots of price deflation. That deflation gets exported to the developed world.

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Falling productivity, but room for reform Emerging market productivity growth has slowed substantially. It’s another sign that investment in many emerging markets, particularly China, has been targeted at the wrong areas. Capital has been misallocated. And emerging markets, generally speaking, are relatively difficult places to do business. They remain a long way behind the great emerging market success story – S.Korea.

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Less favourable demographics have arrived China’s dependency ratio has started to rise (more dependents per working-age person). The change to the one-child policy may have come too late in the day. South Korea’s is also beginning to rise. But South Korea is a much richer country. A falling dependency ratio has thus far boosted growth. Those days are over for many emerging markets. India remains in the midst of its ‘demographic dividend’.

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Consequences… The issues facing emerging markets, are deep-rooted & unlikely to disappear soon. Consequently their drag on global growth, trade & inflation will likely persist. In response, the US Fed & the Bank of England may have to keep interest rates lower for longer. The ECB and the Bank of Japan will likely expand their Quantitative Easing (Buying for longer).

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…and yet more consequences All the while emerging markets will likely remain a source of financial vulnerability. Periodic bouts of financial stress like those seen in recent months should be considered the norm. China’s policy response to its debt problems will be a crucial influence on the fortunes of the global economy in the coming years. Either it cleans up its banks and rebalances growth toward services and consumption (of which there is so far little or no evidence) or it doesn’t & risks heading into financial stress.

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