Emerging Markets and the Health of the Global Economy

It seems as though almost everywhere you look these days, there are signs that after five long years we might finally be about to emerge from the global financial crisis. Last year’s crisis epicentre, the eurozone, has finally emerged from recession. The UK economy is also growing, and at a much faster pace than most were expecting even six months ago. In the US, still the main engine of the global economy, growth levels are almost back to ‘normal’, following last week’s revision of Q2 gross domestic product (GDP) to 2.5%, from the previous 1.75% estimate. 

Granted, current growth rates remain well below the 3%-4% that we have become used to seeing during the most recent periods of economic expansion. However, maybe this recent past was the anomaly.  For example the average long-term GDP growth rate for the UK economy, for the period 1830 to 2008, is a ‘mere’ 1.97%.

However, not everyone is pulling their weight when it comes to the supposed economic recovery. Emerging markets, from Asia to South America, are most definitely not contributing to the ‘green shoots’ narrative. This is perhaps most clearly demonstrated in the currency market; the Indian rupee (INR) has now reached a 20-year low and is down about 20% in 2013.

In August alone, the INR was down by almost 9% against the US dollar (USD), a decline mirrored by many other emerging market currencies; the Indonesian rupiah (IDR) was down by almost 6.5%, the Turkish lira (TRY) declined by over 5%, and the South African rand (ZAR) fell by 4.5%. Money is flowing out from these former darlings of the investment world in an increasingly panicked fashion.  Not to sound alarmist, but this could portend the start of a new leg of the global financial crisis – and represent a pretty effective herbicide for those fragile green shoots…

Learning from history

If this just sounds like scaremongering (who cares about the Indonesian Rupiah anyway!), it is worth remembering what happened in 1998. Then, currency crises in Asia, and later Russia, first crippled the ‘Asian Tiger’ economies, leading to a severe market downturn in the US. This, in turn, set the stage for the current financial crisis, as the Fed’s response to the crisis – aggressively cutting interest rates – began the inflation of asset price bubbles, which effectively caused the 2008 crisis. Not only did this show that emerging market crises can quickly infect the developed world, but it is worth keeping in mind that in 1998, the developed world was twice as big as the developing world; Today, they are pretty much the same size. 

The other reason to be very afraid of what is currently going on in the emerging markets is the challenge this crisis poses to the conventional wisdom that surrounds the emerging market growth story. The idea that these markets, from Asia and Africa to Eastern Europe, represent the economic engine that will keep financial markets buoyant – especially as the more developed markets in Europe and North America begin to slow down due to a combination of demographic changes and economic mean reversion – has been a widely held source of optimism. It has gained credence ever since the start of China’s capitalist reforms in the 1980s, and the explosive growth of the Asian Tigers in the 1990s. 

What the current crisis is telling us is that much of the recent economic growth experienced in these emerging economies may, in fact, have been largely driven by the actions and policies of the developed western economies such as quantitative easing (QE). In other words, much of the recent emerging market growth that we have experienced may well be attributable to unsustainable ‘hot money’ cash flows, rather than any endogenous sources of wealth creation in these economies. Emerging markets may simply represent another ‘bubble’. It is interesting to note that almost US$8 trillion in capital has moved from developed markets to emerging markets over the past nine years  and over half of this amount occurred since the onset of the 2008 financial crisis.

This is an oversimplification, of course. All emerging markets are not created equal and some of them will certainly grow and prosper, due to a combination of healthy demographics, access to natural resources, and a strong economic infrastructure. However, as countries such as India, Indonesia and South Africa experience an exodus of foreign capital at the first hints of US central bank tightening, it is worth asking how much of the emerging market growth story is down to fundamentals and how much of it is just another chase for yield – just a slightly more exotic version of sub-prime mortgage securities. Should this be the case, the next phase of the financial crisis might well be on its way…

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