Economic size & financial might (2014)

For the past decade or so, pundits have been debating, analyzing and discussing the rise of the so-called emerging market economies (EM). Certainly, China’s rise to international prominence has been nothing if not meteoric and was predicted by surprisingly few observers in the beginning. Whether economists doubted the sustainability of real growth rates of 10% or whether the power of compounding confounded them is a moot point by now. 

Recently greater pessimism has begun to spread about the EM growth outlook, and this pessimism focuses at least as much on structural as on cyclical issues. The slowdown in China is widely seen as the result of as necessary to ensure the longer-term sustainability of, admittedly, remains very high growth, north of 7%. The economic reform agenda put forward by the Third Plenum last year was nothing short of impressive, even if it remains to be seen to what extent the Xi-Li leadership will prevail over vested interests that stand to lose from the reforms. 

Source: IMF

By contrast, Brazil and Russia are not only experiencing disappointing growth, but both countries have failed to lay out, let alone pursue a coherent medium-term structural reform strategy. With the election of Modi in India and a very capable central bank leadership under Rajan, the outlook has improved, even if, again, it remains to be seen how aggressively the new government will be pursuing necessary, supply-side reforms. In short, the outlook for the major EM is mixed, but it seems very unlikely that, absent broader reform, the EM will return to the level of growth seen in 2003-11, even if the US sustains solid growth and the euro area returns to a recession-free growth path.

Economic size is one thing, financial size is another. Impressively, four of the ten largest economies are so-called EM. But it is perhaps also noteworthy that the Dutch economy is about the same size as Turkey’s, a country with a population of more than 70 m. Similarly, Norway’s economy with its 5 m people is roughly the same size as Poland, a country of 40 m. What is more noteworthy is the role advanced economies, and especially the large advanced economies, play in global finance. As the EM are typically both smaller and less financially integrated, EM foreign claims do not even begin to compare to those of the advanced economies.

China, as usual, stands out in terms of the sheer size of its foreign claims of around USD 6 tr, not too far behind France or even Germany and Japan, the latter being the world’s largest net creditor. In fact, China has the world’s second-largest net international investment position in dollar terms after Japan. But size is not everything. Nearly USD 4 tr of foreign claims consist of reserve assets in the form of highly-rated sovereign or quasi-sovereign debt securities. This arguably enhances China’s importance even further given that the public sector (mostly the PBoC) controls such a large pot of money, even if it yields China little in terms of influence vis-à-vis its largest debtor, the US treasury. 

The speed with which Chinese assets have increased over the past few years is also pretty impressive. Foreign assets have increased six-fold in dollar terms (even though they have actually declined as a share of GDP!). Chinese foreign assets are twice the size of the combined holdings of Brazil, India and Russia. Excluding Taiwan, China’s foreign assets are larger than those of the ten largest EM combined. Last but not least, the net international investment position (IIP) of Brazil, India and Russia has in dollar terms tended to stagnate or even deteriorate in recent years, while China’s net IIP has improved markedly, rising from USD 1.5 tr in 2008 to almost USD 2 tr today. China is a major net international creditor, while Brazil and India are debtors and Russia’s creditor position is very small.

China will not only remain the most important EM in financial terms, but will also soon be overtaking France and Japan in terms of foreign assets. After all, China’s international financial integration, measured as foreign assets as a share of GDP, is rather limited at the moment. Ongoing reforms aimed at loosening capital account restrictions may lead to greater private-sector cross-border holdings of foreign assets. Private-sector capital outflows would also lead to a greater diversification of Chinese assets holdings, which remain heavily concentrated in public-sector-controlled reserve assets. 

Generally speaking, this is a trend that we can expect to see across the EM. Historically, large reserve holdings were due to the need of the EM to buy “insurance” against a potential sudden stop in capital inflows, the existence of a managed or pegged exchange in the context of balance-of-payments surpluses and/ or extensive restrictions on resident capital outflows. This is what skews EM foreign asset holdings towards low-risk, low-return reserve assets. The move towards greater currency flexibility, generally solid fundamentals and looser capital flow restrictions will lead the EM, and above all China, to become more significant international financial actors. It will nonetheless take time for the even the larger EM (aka BRIC), China as usual excepted, to rival the major advanced economies in terms of their international financial importance.

Commodity dependence & economic outlook for LatAm-7 (2014)

China’s rise and rising commodity prices undoubtedly contributed to the improvement economic performance and fundamentals over the past decade in the LatAm 7 – with the possible exception of Mexico. (The LatAm-7 economies comprise Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela and account for 90% of regional output.) The rise in commodity prices in the decade following 2003 was very significant: energy prices increased four-fold, metal prices three-fold and food prices doubled, while the prices of agricultural products rose 50%.  Not surprisingly, real GDP growth accelerated from 2.5% to 4%.

Recently, much of the region, and especially Argentina, Brazil and Mexico, has suffered from disappointing growth. The ongoing US recovery, the return to moderate growth in the euro zone and more sustainable, if lower economic growth in China will support the outlook. Then again, analysts forecast a decline in commodity prices of around 10% over the next five years. IMF projections point to a significant decline in prices relative to their 2013 peak: food (-10%), agricultural goods (-20%), metals (-26%) and energy (-14%). prices doubled, while the prices of agricultural products rose 50%.  Not surprisingly, real GDP growth accelerated from 2.5% to 4%.

Source: WTO

Recently, much of the region, and especially Argentina, Brazil and Mexico, has suffered from disappointing growth. The ongoing US recovery, the return to moderate growth in the euro zone and more sustainable, if lower economic growth in China will support the outlook. Then again, analysts forecast a decline in commodity prices of around 10% over the next five years. IMF projections point to a significant decline in prices relative to their 2013 peak: food (-10%), agricultural goods (-20%), metals (-26%) and energy (-14%). 

Generally speaking, commodity dependence can be both a blessing and curse. It can prove a curse because terms-of-trade volatility risks undermining the development of a competitive, export-oriented manufacturing base, while the associated high revenue volatility often leads to over-borrowing during boom times followed by financial crises. The often capital-intensive nature of commodity extraction contributes significantly less to human capital formation (enclave effect) than export-oriented industrialisation and a relative lack of economic diversification often makes it harder to develop linkages to other higher-valued-added sectors. 

Where the government relies on commodity rather than tax revenues, the curse may also help undermine democratic accountability, foster corruption and weaken governance. The resource curse is obviously not the only factor impacting the quality of institutions and economic policies. Other factors (e.g. socio-economic conflict, uneven wealth distribution, Anglo-Saxon vs Iberian colonial legacies) also matter. Importantly, too, the resource curse can be overcome (e.g. Chile). Policy-makers can take advantage of unexpected revenue windfalls to raise investment and savings and support long-term economic growth. Unfortunately, the political economy of economic policy in resource-dependent economies is rarely conducive to such an outcome. Hence: more curse than blessing.

Following the end of the Cold War, democracy spread throughout most of LatAm, even if it did not result in stable, highly-institutionalised regimes everywhere. Especially in countries with weak (or weakening) party systems, (outside) candidates often campaigning on populist platforms came to power. In spite of, in some cases, authoritarian tendencies, these countries have nonetheless not turned into fully-fledged autocracies of old. Political analysts have therefore dubbed them “competitive authoritarian regimes” (Levitsky and Way). Not surprisingly, the quality of economic policies in these countries tends to be lower than in more highly institutionalised regimes (think: Venezuela vs Mexico). Commodity windfalls result in higher revenues (commodity rents) rather than taxing voters directly, which makes it tempting to pursue policies that are politically opportunistic in the short-term and unsustainable in the longer term.

In terms of economic management, policies tend towards pro-cyclicality in commodity economies. Rising commodity revenues lead to expansionary fiscal policies, while real currency appreciation on the back of improved terms-of-trade fuels ultimately unsustainable consumption booms. It is therefore particularly desirable to institutionalise anti-cyclical macro-policies that help save at least part of the temporary revenue windfall in the form of fiscal and FX reserves. This is all the more important because commodity price increases tend to be accompanied by larger capital inflows. 

But I digress. So where does all this leave the LatAm-7 in view of potentially weaker commodity going forward? Overall, the LatAm-7 economies have reduced both their external and gross government debt, again with the exception of Mexico. Gross government debt has declined, even if in some cases only minimally so (Chile, Mexico, Brazil, even if the latter has fared better in terms of net debt). External debt is lower everywhere, except in Mexico. Generally speaking, however, Brazil, Chile, Colombia, Mexico and Peru have improved their fundamentals and/ or policy regimes allowing them to withstand commodity price weakness. Due to its reliance on oil-related government revenues (1/3 of total), Mexico is arguably the country most sensitive to declining energy prices among the LatAm-5. This is somewhat offset in terms of the more limited balance-of-payments impact a sustained decline in commodity prices would have on Mexico given its low level of net commodity exports and its significantly greater export orientation towards what is almost certainly going to be the fastest-growing advanced economy, the United States. Moreover, more than 70% of total exports consist of less price-sensitive manufacturing products, as opposed to commodities. 

Add to this, the rather impressive reform efforts of late and Mexico seems well-positioned to cope with lower commodity prices than most the other LatAm-7, its dependence on oil revenues notwithstanding. By the same token, tangibly higher FX reserves, lower external and public debt as well as relatively flexible exchange rates place the other LatAm-5 in a good position to deal with a commodity downturn, even if in such a scenario lower economic growth appears inevitable following the 2003-13 boom years.