Emerging economies have grappled for months with how to tame rising inflation in the face of persistent capital inflows, low ultra-low interest rates in the west and lingering uncertainties about the outlook in Europe, the US and Japan.
But in the space of a few short weeks, the calculus for the developing world’s economic stewards has been turned on its head amid a sudden deterioration of the eurozone crisis and a fading away of the US recovery.
From worrying about rising prices and overheating, developing world policymakers are now watching the unfolding crisis in Europe and the US with growing trepidation, pondering their next moves.
Growth in emerging markets has yet to be hit by the growing global unease. But the challenge facing policymakers – in the Brics as much as in smaller developing nations – is how to prepare for action.
EASY DOES IT
Although many emerging market central banks have only partially tightened monetary policy from post-crisis lows, signs that inflation has peaked could provide authorities space to stimulate growth. Commodity prices have fallen significantly in recent months, while concerns over structural inflation have started to ease.
“Emerging market policymakers are in a good position as they were already getting toward the top end of their interest rate cycles even before we saw a deterioration in the global situation,” says John Cleary, CEO and CIO at EM-focused hedge fund Focus Capital. “That gives them far more room to lower rates and compensate for the global slowdown if required.”
Central bankers canvassed by Emerging Markets are quick to stress they have ample scope to respond to another crisis should their worst fears be realized.
“We stand ready to adjust our monetary policy if the weakness in the world economy continues, and/or if we see very sharp additional measures to make monetary policy more lax in the more advanced economies,” says Agustín Carstens, Mexico’s central bank governor.
Marek Belka, Poland’s central bank governor, says: “We have a level of interest rates which is low enough but also high enough to be moved up or down as the situation requires.”
Brazil has already cut its main policy rate by 50 basis points.
FISCAL FEARS
But there is less consensus over the scope for further expansion on the fiscal front in the even of a renewed crisis.
Substantial fiscal expansion from Beijing to Bogota played a major role in pulling emerging market economies out of the previous crisis. But such action brought with it growing concerns about deteriorating credit quality and rising deficits.
Experts argue that emerging economies, principally in Asia, have the space to take fiscal action should global growth deteriorate. “There is room in many countries for fiscal expansion,” says Pablo Goldberg, global head of emerging markets research at HSBC.
“They have only been tightening a little from what they loosened in 2008-9, but it’s very cheap right now to fund themselves in the market and no-one will get too upset if people extend their GDP ratios a little bit in the current environment.”
But not all emerging countries are well positioned on the fiscal front. “We haven’t been able to undertake fiscal consolidation, or the creation of fiscal space to the extent we would have liked because of the repeated uncertainties in the western world and the dampened global growth environment,” says Pravin Gordhan, South Africa’s minister of finance.
Phil Suttle, director of global macroeconomic analysis at the Institute of International Finance, a trade association representing the world’s largest banks, warns that even where countries have the fiscal space to respond, they should not throw caution to the wind.
“Any easing should be done very cautiously. The emphasis in emerging markets should be very much a taking-the-punchbowl-away approach to running the system,” he says.
“The worst thing for the emerging world would be to loosen credit standards, cut rates and compensate for global weakness by creating an excessive expansion domestically.”
He says that there is already a risk of this happening, citing Turkey, Brazil and to a lesser extent China and India as causes for concern on this front.
LESS EXPOSED?
There is cautious optimism that stronger domestic and intra-developing nation demand, coupled with lessons learned from past emerging market crises has left these countries better-placed to withstand and to respond to a renewed downturn – even though many acknowledge that nowhere would be spared another global financial crisis.
Thai central bank governor Trairatvorakul points out that 70% of the country’s exports are to non-G3 nations – a large proportion with neighbouring countries in east Asia. In addition, he says, “growth momentum is increasingly being driven by domestic demand, consumption and investment.”
For more export-dependent nations with small domestic markets, policymakers admit they have limited tools at their disposal to guard against a downturn in developed markets. This is particularly true for smaller countries in central and eastern Europe.
Czech finance minister Miroslav Kalousek says that while the government is encouraging a greater diversification of trade with faster-growing emerging nations, a significant slowdown in the eurozone would nevertheless have a large impact on the country’s economy. “The government and the central bank possess only a few instruments to provide stimuli to a small open economy if there is a slowdown in our main trading partners,” he says.
But boosting domestic demand and trade links with other emerging economies could prevent a meltdown in emerging markets on a similar scale to what was seen in 2008.
Nobel laureate economist Joseph Stiglitz tells Emerging Markets: “I’m fairly confident that [emerging markets] are going to be able to manage their way through if there’s a drop in exports and a slowdown in the US and Europe,” pointing to “vast untapped domestic demand” as well as growing trade links with other parts of the world.
Investors broadly share this belief about the emerging world’s ability to withstand the worst of any renewed downturn.
“We believe that structurally EMs are better, rates in DMs will have to stay low, so structurally we will see a comeback for the carry trade favouring emerging markets once the dust settles,” Goldberg says.
Cleary believes that much of the EM sell-off may have already happened, pointing to attractive valuations in Latin American equity markets in particular.
“A big part of the panic and flight to cash has already happened, and recent volatility has given investors more opportunities to scale positions to places that they’re more comfortable,” he says.
EXTREME VOLATILITY
But while many would welcome continued investor confidence, the prospect of a renewed surge of capital inflows points to longer-term challenges for emerging markets.
A further round of quantitative easing in the US would likely spark a further flood of speculative capital into emerging markets. This is of particular concern to policymakers in Latin America, which has traditionally born the brunt of such speculative inflows.
“We are very concerned about what is happening in the United States, especially if they continue to believe that a QE3 is the answer to the problem,” says Colombian finance minister Juan Carlos Echeverry.
The challenge is one of setting policy to manage both short-term and long-term concerns, aware that over-stimulating growth now could store up additional challenges in the event of large, speculative inflows in the future.
“Emerging market policymakers face the problem of how to deal with whatever waves may be coming from abroad, both short-term and long-term,” says HSBC’s Goldberg. “The risk in the immediate future is an outflow of funds and a sudden deterioration in currencies. But in the longer-term, once the dust has settled, emerging markets may see massive capital inflows, as interest rates in developed markets will have to stay low.”
Greater global coordination is therefore needed in managing monetary, fiscal and currency policies in the run up to the G20 leaders’ summit in Cannes in November, experts say.
South Africa, for one, is especially keen to see more policy coordination at the G20 level. As a large emerging market economy with relatively open capital account, the country has suffered sharp capital flow and currency swings in recent years.
“It’s clear that we require a much more urgent global dialogue that will ensure that [with regard to] overvaluation of currencies and the imbalance in the monetary system, we don’t have some winners and some losers. We are battling to get there, but we’re not there yet,” he says.
CONTROLLING THE FLOW
Yet given the likelihood of continued policy mismatches between rich and developing countries as a global downturn gathers pace, analysts say further capital controls and currency restrictions are likely.
“There needs to be coordination on currencies, otherwise we could see a race to the bottom in terms of devaluation” says Peter Attard Montalto, EM economist at Nomura.
But with different nations facing vastly different challenges and seemingly seeking different paths out of the current crisis, prospect for genuine coordination are grim, he says. What’s more likely is an increase of “unorthodox” and “postmodern” policy responses – such as those employed over the past year by Turkey, where the central bank has cut rates while using administration measures to temper inflation and currency appreciation.
“Policy coordination will be very difficult if not impossible,” he says. “Each country is out there for themselves. The challenge will be how to respond in a world without global coordination.”