Feature Stories | Jun 06 2011
(This story was originally published on May 25, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).
– EMs are driving global growth
– EM policy is thus now extremely important
– EMs have made big strides but there's more gap to close
– That gap nevertheless offers opportunity
By Greg Peel
2011 has proven to be a year of inflation fears which have replaced the fears of global deflation prevalent shortly after the GFC. The Fed won't admit it, but global inflation has been driven as much by stimulatory US monetary policy, ensuring a weaker US dollar, as it has by expectations of ongoing growth in emerging markets through continued industrialisation and urbanisation.
Easy Fed policy has been implemented to ensure a US economic recovery. Whereas once we considered emerging markets (EMs) to be “fragile” and developed markets (DMs) to be “robust”, one can argue that those labels should currently be reversed. The global recovery to date out of the GFC depths has seen an EM contribution to GDP growth of 70%. Where would the DMs be right now without the EMs?
It was back in the 1970s when the world first began to see the potential upside offered by markets yet to “emerge”, meaning those economies with living standards some distance below standards taken for granted in developed markets. While China is seen as a leader and proxy for all EMs, the category now also contains the rest of Asia ex-Japan, India, parts of the Former Soviet Union and Eastern Bloc, Mexico, South America, parts of the Middle East and South Africa. The DMs include the US, UK, Western Europe, Japan, Canada, Australia and New Zealand. At this stage of the game we still consider, say, Brazil as emerging while Greece is developed, despite what are glaringly divergent economies at present.
From the 1970s into the 1980s, many EM economies enjoyed a growth surge but with accompanying volatility and fragility. They were like infants taking their first steps without much fear but little in the way of experience. DM central banks were not controllers of inflation in the 1970s, so post the end of the Gold Standard DMs were soon suffering inflation levels of 10-20%. EMs, however, saw inflation levels much higher still. Hence they suffered inevitable busts amongst the booms.
By the 1990s the DMs had brought inflation under control with the help of the early 1990s recession, and indeed Japan fell into deflation and has been suffering ever since. Having had to suffer shocks like the Russian debt default and the Asian Currency crisis in the late 1990s, by the 2000s the EMs were also learning to keep a lid on inflation. Slowly their monetary policy experience was growing. They also learned to keep currency rates low and foreign reserves high so as to avoid another crisis.
The upshot was that the DMs got themselves deeper and deeper into debt from consuming EM exports. EM economic growth surged but only in the export sector. Domestic economic growth remained immaterial. The result was the growth of the symbiotic but also potentially internecine relationship we now label the “global imbalance”. When the US and Europe went down in the GFC, so too did China.
China was able to quickly pick itself up nevertheless, aided by all those foreign reserves it had hoarded and by a pegged currency. And that's where we find ourselves now. The EMs are trying to keep economic growth and inflation under control but there is little doubt amongst economists the EMs will continue to drive global growth for a long time to come. Meanwhile the DMs are beaten down and remain fragile, with the US recovery stalling ahead of the end of QE2 and European peripherals threatening to bring down the eurozone. Japan has problems of its own.
The world has now become heavily reliant on the EMs as the global growth driver. The question is: are the EM authorities now fully capable of grasping this responsibility and steering the global ship, or is there still a risk, as financial markets fear, that EM authorities could stuff it up?
As the growing EM middle class attests, the EMs are rapidly closing the gap on the DMs. Morgan Stanley analysts Manoj Pradhan and Alan Taylor suggest, however, that it was easier for EMs to be seen and thus priced as “risky” in earlier decades as it allowed understandable room for policy error. With EMs now seen as global drivers for the foreseeable future, that margin for error “seems to have shrunk awfully quickly”. EM policy makers now not only have to consider domestic and global conditions, but also global rebalancing and the structural shift of EMs towards DMs. EMs have now “sliced away a huge part of the gap between themselves and EM economies,” note the Morgan Stanley analysts.
Yet just because EMs are driving 70% of global growth does not mean EMs have stopped emerging and become suddenly developed. There is still a gap, based on policy, market development and standard of living measures. There is thus still room for improvement, but this is also a good thing given scope for further improvement, suggests Morgan Stanley, also means scope for sustained growth.
Inflation is currently running higher in EMs than in DMs, which is not surprising given the much higher rate of economic growth, the higher proportion of food and energy spending in the EM citizen's household budget, the catch-up still occurring in wages, and the lack of debt burden compared to the DMs. Yet in headline terms EM inflation is really not that much higher than DM inflation, and the gap is certainly nothing like it was in the 1970s when EMs suffered hyperinflation. World financial markets are worried, for example, about Beijing bringing China into a hard landing through excessive policy tightening to curb inflation. Morgan Stanley suggests “the quality of growth in EM economies has been staggeringly better of late. While DM economies have actually regressed, with lower and more volatile growth, EM growth has improved dramatically and on a steadier trend than in the past”.
The problem for EMs now is that much thinner margin for error. Whereas once runaway levels of inflation could be brought back down to earth without much upsetting GDP growth rates, now EMs have to clearly sacrifice growth to control inflation. There is a much greater risk of shifting policy either not enough or too far. The responsibility of global rebalancing, to mutual benefit, rests with the EMs.
“If the process of global rebalancing proceeds as we expect,” says Morgan Stanley, “the nominal and real appreciation of EM currencies and the rise in real yields globally could put EM economies on a more sustainable growth trajectory while giving DM economies better access to positive spillovers from continued EM growth”.
It's simple in theory. If EMs can successfully manage real currency appreciation, meaning nominal appreciation plus inflation, then they can grow their domestic economies without destroying their export economies and DM export economies can benefit by tapping into the growing domestic EM economies. Balancing on a beach ball in a swimming pool is also simple in theory. Morgan Stanley nevertheless believes that great EM strides have been made over the past decades.
The export concentration of EM growth was around 4-5 times in 1990 but is only 2-3 times now, MS notes. China's GDP growth rate fell from double digits pre-2008 to under 7% quickly after, which emphasised that China's GDP was still too reliant on exports and not enough on the domestic economy. DM export demand has collapsed and remains subdued, but China is heavily stimulating domestic growth through monetary and fiscal means.
The risk is, as Beijing well knows, that stimulus leads to an asset price bubble (property and stock prices). Such a risk has prompted tightening measures.
EMs are likely to tolerate moderate levels of inflation, MS suggests, but within limits. The risk is inflation is allowed to remain to the high side in order to avoid slashing growth but then becomes entrenched as workers start to push harder for higher wages. Such a push has already been experienced in Southern China, National Australia Bank's economists note. Managing inflation also requires careful currency appreciation.
There is, however, more to the story.
EM authorities now have a much greater and more nuanced global responsibility as EMs rapidly converge on DMs. But with this closing of the gap comes much greater financial market development, notes Morgan Stanley. More developed markets should mean better allocation of capital, and financial markets should provide more clues for authorities about economic health, leading to more informed and effective policy decisions.
Beyond the financial markets themselves, economists identify investment in public goods such as education and health as being instrumental in supporting economic development, notes MS. Here, EMs have made significant strides.
Measuring health in terms of life expectancy and education in terms of years of schooling, MS notes that by 2005 EM health had reached the equivalent of DMs in the 1970s and education the equivalent of DMs in 1985. These dates may seem like a long time ago for those in DMs, but realistically such achievement suggests a striking catch-up.
Even deeper, fundamentally, than public goods in respect to the potential for sustained economic growth are the considerations of political freedom (democracy) and economic freedom (law, stability and lack of corruption). Here, too, MS suggests the progress made by EMs has been striking. However there is still some way to go before EM citizens enjoy the same freedoms DM citizens take for granted.
It is the above gaps which suggest, on definition, that EMs are not yet at a stage where we can call them DMs. But again the point is that the further catch-up required in itself ensures sustained EM growth ahead.
Then there is the matter of looking at the gap the other way. Just as EMs are rising to meet DMs, DMs are doing their best to close the gap from their own side. Take peripheral Europe as an example.
More fundamental than current slow growth in the DMs is the factor of age. DMs enjoyed their post-war boom at least one generation before the EMs kicked into gear. Before the 1980s, DM youth was happily supporting the DM aged. Since the 1980s the equation has swung such that the DM aged will eventually overwhelm DM youth. In EMs, the equation is very much still on the youth side and there it will be a very long time, MS suggests, before the equation turns.
So aside from the delicate task of economic management facing the EMs as they converge on the DMs at a time when such convergence is the world's only driving force, and the risks inherent therein, the EM story looks to be a pretty solid and sustainable one as determined by Morgan Stanley's analysis.
There is, nevertheless a yang to the yin of strong EM growth, as MS notes, and that relates not to the gap between DM and EM but the gap between the haves and the have-nots within the EMs. Rapid growth presents the risk that the disenfranchised fall further behind in standard of living terms, leading to popular unrest. We need only look to the Middle East and North African countries currently in turmoil for that very reason.
Beijing has been very quick to quell any hint of similar unrest. Brazil will soon host the Olympics, yet Rio is home to huge sprawling ghettos. Eastern European populations are still dominated by peasants. EM authorities need to be very careful about wealth distribution in capitalist economies least economic growth all comes to nought.
So where does Australia lie in all of this?
Obviously Australia is a DM, but as a significant exporter to the EMs it is both a proxy for, and beholden to, EM economic growth. It's not just an exposure to China, or India coming up behind. National Bank notes that around a quarter of Australia's exports go to the “Asian Tigers”, which sit in the crescent stretching around from South Korea to Thailand. That means Australia exports almost as much to the Tigers as to China. So it's not just Beijing policy Australia needs to be concerned about.
If Morgan Stanley's analysis and conclusions prove accurate then Australia can look forward to benefiting from sustained EM growth, but there is always that risk, as MS identifies, that EM policy makers don't quite get it right.
UBS analysts note, for example, that Asian monetary policy for the most part remains inflationary despite apparent monetary tightening and data suggesting slowing growth. Real interest rates, for example, remain negative everywhere in Asia bar India.
Inflation growth is expected to moderate in the second half of 2011 because of slowing GDP growth, because food prices are expected to ease (and indeed all commodity prices have now seen a correction) and because of the effects of seasonal destocking of raw materials. There is thus a risk, however, that Asian policy makers relax. Core inflation, which the DMs use as the true inflation gauge, is rising in much of Asia, UBS notes, due to easy monetary policy.
“It's generally not a good idea to bet on hard landings for Asia,” says UBS, “but one should remember that markets care intensely about rates of change and less so about the level of economic activity”. What the analysts mean here is that financial markets are more likely to panic if China's GDP growth rate falls to 8% from 10% than they are to consider 8% a level of robust, sustainable growth. In other words, markets are still very open to short-term volatility even if the long-term picture remains healthy.
So the good news for Australia, and the world, is that while EMs are not yet the new DMs, despite driving the global economy at present, substantial progress has been made in closing that gap and the remaining gap provides the potential for further growth. Success nevertheless relies on EM authorities getting tricky policy right, and there will still be plenty of ups and downs in the meantime.
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