Marcus Wright RBS Economics November 2015

Emerging Markets: Gimme Shelter

What’s this about?

- Growth in emerging markets is slowing. This is concerning. We consider two key questions:

1. What are the problems in emerging market economies?

2. Why does that matter to us?

Emerging markets matter more than ever

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1994 1996 1998 2000 2002 2004 2006 2008 2011 2013 2015

Share of the Global Economy (%)

Developed EconomiesEmerging EconomiesEmerging Asia

Source: IMF

0%10%20%30%40%50%60%70%80%

1994 1996 1998 2000 2002 2004 2006 2008 2011 2013 2015

Contribution to Global GDP Growth

Developed EconomiesEmerging EconomiesEmerging Asia

Source: IMF

• Emerging markets have accounted for 50%-60% of global output & 70% of global economic growth each year since the crisis.

• They are much more important to the global economy compared with the late 1990s when the last EM crisis struck.

• In other words, an EM slowdown can do a lot of damage to the outlook for global growth.

Pass the credit parcel

• While credit growth stagnated in developed economies following the crisis, it rebounded quickly in emerging markets.

• But now slower EM credit growth and Eurozone deleveraging has left global credit growth in the doldrums.

-5%

0%

5%

10%

15%

20%

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Outstanding Private Sector Credit to Developed and Major Emerging Economies

(% Y/Y Change)

Source: BIS

-10%

0%

10%

20%

30%

40%

2000 2002 2004 2006 2008 2010 2012 2014

Outstanding Private Sector Credit(% Y/Y Change)

Developed Economies Emerging EconomiesSource: BIS

Quelle surprise – China is the main culprit

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China - Credit to Private Non-Financial Sector(Oustanding, $ Trillion)

Source: BIS

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20%

40%

60%

80%

100%

2001

2002

2003

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2007

2008

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2011

2012

2013

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2015

Outstanding Credit to China's private sector...

As % of the USAs % of global

Source: BIS

• Credit to China’s non-financial private sector has risen a staggering $15trn since the crisis – close to the size of the US economy.

• China’s credit pile has risen from a mere 20% of the level of the US to 80% in just six years.

• When credit rises that much so quickly, much of it inevitably gets wasted.

A reckoning awaits China’s banking sector

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2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Liabilities of Chinese Corporates(Trillions of RMB)

TransportationManufacturingMining, utilitiesNonfin servicesConstruction and real estate

Source: IMF

• It’s the corporate sector that has driven China’s debt increase.

• Hong Kong’s build-up has been even greater, relative to the size of its economy.

• China’s banking sector is likely to be sitting on non-performing loans in excess of official figures.

• China can afford the clean-up but the debt overhang and banking sector repair will drag on growth.

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Corporate Sector Debt(% of GDP Change since Crisis)

Source: BISNon-financial Corp Sector

That debt is becoming more of a burden

• Emerging economies have gorged on debt. Consequently, since the crisis, they are devoting more of their incomes to repaying it.

• Developed countries by contrast are devoting less.

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UK Rest of World

USJapan

France AustraliaGermany

NetherlandsCanada

SpainItaly

Sweden

Banking Exposure to China and HK by Country

(% of $1.5 trn global exposure)

Source: BIS

• Despite China’s relatively closed financial system, global banking exposure to China is $1.5trn.

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Den

Spa

UK Hun

Por

SA US

Aus

Fin

Jap

Ger

Ita Kor

Cze

Pol

Mex

Swe

Bel

Indi

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don

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Neth

Thai

Mal Tur

Rus

HK SA

RCh

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Debt Service Ratios- Change since 2008, Private Non-Fin Sector

Source: BIS

Mainly Developed Economies

Mainly Emerging

Economies

A big score…off-shore

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2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Emerging and Developing Economies -Debt Securities Outstanding($ Bn)

At Home

Including Offshore Borrowing

Source: BIS

China - Offshore Bonds by IndustryReal Estate

Finance

Oil and Gas

Utility and Energy

Computers and ElectronicsMetal and Steel

TransportationSource: IMF

• Offshore bond issuance results in the classic emerging market problem – currency mismatch on the balance sheet of EM firms.

• A move toward tighter US monetary policy could expose these vulnerabilities.

• Unsurprisingly, China is

again the major player with real estate, finance and oil & gas the main sectors.

The problems are more than debt alone• Having previously grown

much faster than the pace of global GDP growth, world trade growth is now slower.

• Emerging markets hoped for a strong rebound in export growth following the crisis but it never materialised. It’s not just due to the Eurozone.

• China’s slowdown is transmitting across other emerging markets as reduced demand for their exports.

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40%

2003 2005 2007 2009 2011 2013 2015

Export Volume (% Y/Y Change)

Emerging Economies

Emerging Asia Source: CPB

Pre-crisis average: 10%

Post-crisis average: 4%

-15%

-5%

5%

15%

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Global GDP Growth v Global Trade Growth(% Y/Y Change)

Global Trade Growth

Global GDP Growth

Here comes the deflationary wind

• Emerging markets pushed investment in productive capacity, housing & infrastructure in response to the global slowdown.

• The global economy benefitted because developed economies pulled back.

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2007 2008 2009 2010 2011 2012 2013 2014 2015

Investment as Share of GDP(2007 = 100)

Developed Economies Euro AreaEmerging Economies

Source: IMF

-4 6 16 26 36

ChinaS. Korea

PhilippinesTaiwan

SingaporeMalaysia

Months in Producer Price Deflation(Over past 36 months)

Source: Macrobond

• Too much investment. Too much capacity. Lots of price deflation.

• That deflation gets exported to the developed world.

Falling productivity, but room for reform

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1970s 1980s 1990s Pre-Crisis 2011-2012 2013-2014

EM Labour Productivity per Person Employed (% Y/Y Change)

Source: Conference Board

• Emerging market productivity growth has slowed substantially.

• It’s another sign that investment in many emerging markets, particularly China, has been targeted at the wrong areas. Capital has been misallocated.

• And emerging markets, generally speaking, are relatively difficult places to do business.

• They remain a long way behind the great emerging market success story – S.Korea.

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90Ease of Doing Business(Distance to Frontier of Best Practice, 100=best)

Source: World Bank

Less favourable demographics have arrived

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1950 1960 1970 1980 1990 2000 2010 2020 2030

Population Dependency Ratio

China IndiaS.Korea

Source: UNRatio of population aged 0-14 and 65+ per 100 aged 15-64

Forecast

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1950 1960 1970 1980 1990 2000 2010 2020 2030

Population Dependency Ratio

Selected Emerging Economies

Developed Economies

Ratio of population aged 0-14 and 65+ per 100 aged 15-64 Source: UN

Forecast

• China’s dependency ratio has started to rise (more dependents per working-age person). The change to the one-child policy may have come too late in the day.

• South Korea’s is also beginning to rise. But South Korea is a much richer country.

• A falling dependency ratio has thus far boosted growth. Those days are over for many emerging markets.

• India remains in the midst of its ‘demographic dividend’.

Consequences…

• The issues facing emerging markets, are deep-rooted & unlikely to disappear soon. Consequently their drag on global growth, trade & inflation will likely persist.

• In response, the US Fed & the Bank of England may have to keep interest rates lower for longer. The ECB and the Bank of Japan will likely expand their Quantitative Easing (Buying for longer).

…and yet more consequences

• All the while emerging markets will likely remain a source of financial vulnerability. Periodic bouts of financial stress like those seen in recent months should be considered the norm.

• China’s policy response to its debt problems will be a crucial influence on the fortunes of the global economy in the coming years. Either it cleans up its banks and rebalances growth toward services and consumption (of which there is so far little or no evidence) or it doesn’t & risks heading into financial stress.

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