Why emerging market resilience may not last

2nd October 2012

The relative calm enjoyed by emerging market economies in recent years looks increasingly at risk as conditions on the global stage weaken, the International Monetary Fund has warned.

In its latest World Economic Outlook, the IMF warned that the resilience which has been seen in emerging markets over the past two decades could still be threatened by external and domestic shocks.

Will it last?

The report – titled Resilience in emerging market and developing economies: Will it last? – notes that these countries have spent more time expanding and suffered smaller downturns than advanced economies over the 20 or so years.

Despite the disruption caused by the "Great Recession", emerging markets have benefited from growth rates that advanced economies can only dream of in recent years. While the developed world struggled for growth they saw GDP increase by 6.3% during 2011, according to Capital Economics – although this is forecast to fall to 4.8% this year.

The IMF expects emerging markets to retain their resilience. But it adds: "The caveat, of course, is that the relative calm of the past two years could well be temporary."

Stalling economic recovery in the developed world is noted as the strongest external shock on the horizon, while capital outflows and credit booms are leading domestic risks.

"There is a significant risk that advanced economies could experience another downturn, as continuing sovereign and banking tensions in Europe and the so-called fiscal cliff in the United States threaten to put the brakes on growth," says the IMF.

The US

Speculation that the US will drop back into recession are mounting as January approaches, when a combination of tax rises and spending cuts increase the likelihood that growth in the world's largest economy will be reduced by between 3.5 and 4 percentage points in 2013.

Leading economist Joseph Stiglitz describes the issue as "a real danger". He told the Sunday Telegraph: "There are so many political battles ahead that the likelihood we avoid all of these elements that will then avoid the fiscal cliff is very problematic."

The Eurozone

In the eurozone – a major market for emerging economy powerhouses like China – the risk of recession is more immediate as widespread austerity measures and develeraging continue to choke growth.

Indeed, Monday's Markit Eurozone Manufacturing Purchasing Managers' Index for September suggested the region has already landed in a new recession after finding that the weakness in production that started at the periphery has spread to core economies such as France and Germany.

Chris Williamson, chief economist at Markit said: "Despite seeing some easing in the rate of decline last month, manufacturers across the euro area suffered the worst quarter for three years in the three months to September.

"The survey is consistent with manufacturing output falling at a quarterly rate of perhaps as much as 1%, which means the sector will act as a severe drag on economic growth. It therefore seems inevitable that the region will have fallen back into a new recession in the third quarter."

So what about the risk of domestic shocks? 

Breakout Nations: In Pursuit of the Next Economic Miracles author Ruchir Sharma argues in FT's Deals & Dealmakers blog that investors appear to be growing wary about betting on the continued rise of emerging markets as an asset class.

"The indiscriminate capital flow that propelled the emerging markets has dried up," Sharma writes.

"In the first half of 2012, Turkey was the best performing emerging market, up 26%, and Brazil was the worst, down nearly 10%, as investors realised that they need to think about these markets as individual countries, not one class."

Without strong capital inflows, as the IMF notes, the outperforming growth of emerging markets seem less assured and the strength of their continued resilience may be cast into doubt.

This case for this may be strengthened by the capital flowing out of China – by far the largest emerging market and the second largest economy in the world. As the Wall Street Journal reported, investors and businesses have been pulling money out of China.

"China's banks have been sellers of dollars in five of the last 10 months, purchasing a paltry 145 billion yuan in foreign exchange over that combined period, considerably less than the 905 billion yuan that flowed into the country through the trade surplus," the paper reports.

"That is a stark contrast with much of the past decade, when confidence in China's growth and hunger for yuan meant China's banks were buying up not just the entire trade surplus, but also considerable inflows of speculative capital, known as hot money."

The Chinese government has been attempting to stem hot money into the economy, in order to cool its heated property market and deflate asset bubbles. However, confidence and investment could be threatened if capital outflows cause prices to fall too far.

Clearly this would put the Chinese authorities' growth-focused strategy at risk. Coupled with the slowdown in demand for its exports from the eurozone and the US, there are clear threats to China's resilience to global economic uncertainty, as warned by the IMF.

And if China is unable to avoid re-coupling with the developed world, it seems likely that other emerging markets could follow suit.


More on Mindful Money:

India’s long, uncomfortable history with FDI

Looking on the bright side of the emerging market slowdown

The Financialist: 'Emerging market investment: looking beyond the BRICS'

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