Emerging Markets Will Not Rescue the Rest of the World

8/7/2019 Emerging Markets Will Not Rescue the Rest of the World

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Global Economics Focus 1

GLOBAL

ECONOMICS FOCUS8thN

ov.

2010

Emerging markets will not rescue the rest of the world Emerging market economies will continue to grow rapidly over the next few years. But with

current account surpluses in most of Asia and among oil producers likely to remain high, this will

not be of much benefit to the developed world. Whats more, while some emerging economies are

likely to become an increasingly important source of global demand, there is a growing risk of asset

bubbles, with Latin American countries looking particularly vulnerable.

We think emerging economies will grow by an annual average of 6% over the next two years roughly four times as fast as the G7. But for this rapid growth to pull the developed world out of itsrut there would have to be a significant expansion in import demand from the likes of China and the

oil producers. Put another way, the emerging worlds current account surplus needs to fall.

In the near term, at least, this seems unlikely. The draft outline of Chinas forthcoming five-year planputs a heavy emphasis on the need to boost domestic demand. But, on the ground, imbalances are

rebounding and powerful vested interests are likely to frustrate efforts at rapid reform. The

prospects for rebalancing elsewhere in Asia are better but even so it will still be a slow process. And

unless commodity prices fall sharply, the oil producers surpluses look here to stay too.

Admittedly, other parts of the emerging world are likely to boost global demand over the comingyears. The likes of Brazil, Mexico, Poland, Turkey and some smaller economies in Eastern Europe

and Latin America all have huge investment needs. But at the same time domestic savings in thesecountries are very low. One way to finance a much-needed pick-up in investment is therefore to

borrow from economies with excess savings in effect running current account deficits that could at

least in part offset the surpluses of Asia and the oil producers.

But while this could provide a degree of support for the developed world, it is unlikely to havemuch impact if the surpluses of Asia and the oil producing nations remain large. There are also risks

notably of overheated growth and asset price bubbles in emerging market deficit economies.

The upshot is that the developed world will not be able to rely on emerging markets to pull it fromits current malaise. Instead, we are facing a period in which emerging markets grow relatively

strongly while the G7 recovery is slow. This could be a combustible mix as G7 policymakers ask

whether their emerging world counterparts should not be doing more to expand global demand.

Mark Williams & Neil ShearingTel: +44 (0)20 7808 4985

North America Europe Asia2 Bloor Street West, Suite 1740 150 Buckingham Palace Road #26-03 Hitachi Tower

Toronto, ON London 16 Collyer Quay

M4W 3E2 SW1W 9TR Singapore 049318

Canada United Kingdom

Tel: +1 416 413 0428 Tel: + 44 (0)20 7823 5000 Tel: +65 6595 5190

Managing Director Roger Bootle ([email protected])

Chief International Economist Julian Jessop ([email protected])Senior Emerging Markets Economist Neil Shearing ([email protected])

Senior China Economist Mark Williams ([email protected])


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2 Global Economics Focus

This Focus is an adapted version of a presentation

given at the Capital Economics Annual

Conferences in Europe and North America in

September and October 2010.

In contrast to the developed world, the major

emerging economies are already back to business

as usual and look set to grow substantially faster

than the West for the foreseeable future. This Focus

asks whether the likes of the US and Europe willbenefit from this growth.

Fast GDP growth in emerging markets is nothing

new the emerging world has outperformed by a

wide margin for about a decade now. (See Chart

1.) But for most of that period, rapid growth,

particularly in Asia, did not do much to support

economies in the high-income world. This is

because emerging market exports have grown by

much more than imports. So when we look ahead

we need to bear in mind that rapid growth inemerging markets will only help the developed

world if that pattern changes and the emerging

worlds current account surplus falls.

CHART 1:GDP(MARKET EXCHANGE RATES,% Y/Y)

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80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10F

Emerging and developing economies

Advanced economies

Sources IMF, Capital Economics

How did we get here?

In the years running up to the crisis, the major

emerging world surpluses could be divided into

three roughly equal parts: China, the rest of Asia

and the oil exporters (taken here to be OPEC plus

Russia). Their combined surplus peaked in 2007.Last year the surplus had fallen by about a third as

a share of world GDP. (See Chart 2.) Of course, the

emerging worlds surplus declined because export

demand collapsed. Over the next few years the

hope must be that the surpluses will continue to

come down due to stronger demand within

emerging markets, so that their rapid growth is

positive for the rest of the world.

CHART 2:CURRENT ACCOUNT SURPLUSES (%WORLD GDP)

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0.0

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1.0

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2.0

2.5

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0.0

0.5

1.0

1.5

2.0

2.5

92 94 96 98 00 02 04 06 08 10

Oil Producers

China

Other Asia

Source IMF

Is China already rebalancing?

What are the chances that the surpluses continueto fall? We will start with China, before moving

onto the other regions.

Chinas current account surplus has more than

halved to around 5% of its GDP since the peak.

(See Chart 3.) Clearly a lot of that rebalancing

was involuntary. Exports plunged. There was also a

big increase in imports, partly to fuel stimulus-

linked investment. But hopes that this might

develop into a lasting rebalancing of the Chinese

economy have already been dashed.

CHART 3:CHINA CURRENT ACCOUNT SURPLUS (%GDP)

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10*

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12

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*Official estimate for 1H 2010

Sources CEIC, SAFE

Emerging markets will not rescue the rest of the world


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The global recovery in exports has brought a rapidrebound in the trade surplus. In fact the surplus is

already almost as big now as it ever was. (See

Chart 4.)

CHART 4:CHINA TRADE SURPLUS ($BN,SEAS.ADJ.)

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00 01 02 03 04 05 06 07 08 09 10 11

Monthly surplus

3m average

Sources Thomson Datastream

This turnaround is not just about the global

rebound though. There were a lot of stories earlier

in the year contrasting the strength of Chinese

consumption with the weakness elsewhere. For

example, China recently overtook the US as the

worlds largest market for cars. But, as Chart 5shows, the hopeful signs that Chinese consumer

spending was accelerating are already fading. Last

years spurt in growth of car sales has rapidly died

away. Sales growth is back below the pre-crisis

rate in y/y terms. In other words, the long-awaited

acceleration in consumer spending that would be

needed to bring down the surplus at current levels

of output growth has not materialised.

CHART 5:CHINA AUTO SALES

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120

140

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01 02 03 04 05 06 07 08 09 10

% y/y

% 3m/3m (seas. adj.)

Source Thomson Datastream

Income growth still weakSo Chinas economy has not rebalanced that far

and what rebalancing we have seen is already

going into reverse. This shouldnt be a surprise.The government can stimulate spending in the

short term, but a sustained pick-up in household

spending growth is much harder to bring about

because the roots of weak consumption (relative to

production) are in the very structure of the Chinese

economy. The fundamental issue is how little of

Chinas income ends up in the pockets of its

workers.

Chinese households take home little more than

half of national income, an extremely low levelthat has actually fallen over the past decade. (See

Chart 6.) In order to reverse this shift, the

government would have to scrap the incentives

that currently channel income into profits and the

incomes of the richest households where they

tend to be saved rather than the wages of average

workers. This would mean, for example, ramping

up interest rates so that more investment goes into

labour-intensive sectors; breaking up the state-

owned monopolies; getting rid of subsidies on

energy and land; and, of course, allowing thecurrency to rise.

CHART 6:CHINA HOUSEHOLD INCOME &CONSUMPTION (%

GDP)

30

35

40

45

50

50

55

60

65

70

1992 1994 1996 1998 2000 2002 2004 2006

Household income (LHS)

Household consumption (RHS)

Source CEIC

In practice, big firms, many of them state-owned,

have prospered from access to cheap loans, energy

and land, and the implicit subsidy of the exchange

rate. They will fight to hold on to those advantages.

These vested interests make it hard for the

government to undertake any meaningful reform.

The recent third quarter GDP breakdown

demonstrates how far there is to go. According to


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Chinas statistics bureau, real GDP grew 9.6% y/ylast quarter but real urban disposable incomes rose

only 7.5%. Households still seem not be sharing

equally in the spoils of growth.

The government did loosen its control over the

renminbi earlier this year. But the 2% gain we

have seen against the dollar since then can hardly

be described as a dramatic shift in policy,

particularly when the dollar has been weakening

more sharply against the euro and yen. Even the

modest pace of appreciation seen over the past fewweeks is likely to slow once the upcoming G20

Summit is out of the way. (See Chart 7.)

CHART 7: RENMINBI/DOLLAR EXCHANGE RATE (INVERTED)

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7.0

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6.6

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7.0

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2007 2008 2009 2010

Renminbi stronger

'Dramatic' Policy Change

Source Bloomberg

More promising signs elsewhere in Asia

So seems little prospect China retooling its

economy to be led by consumers quickly enough

to help rescue the developed world from its current

malaise. The situation is somewhat different in the

rest of Asia. The ageing of Japans population is

gradually bringing down the surplus, one retiree ata time. But the government is clearly not eager to

speed up that rebalancing, as we can see from the

recent intervention to keep the yen down.

For emerging Asia outside China, the growth of

current account surpluses since late 1990s has

been not so much about a surfeit of saving as

relatively weak investment and the desire to build

up precautionary stocks of foreign exchange

reserves. As Chart 8 shows, Asian households

outside of China consume only a little less as ashare of national income than those in the G7.

CHART 8:HOUSEHOLD CONSUMPTION (AS A % OF GDP)

(2008)

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60

70

80

0

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60

70

80G7 Average


When it comes to investment, governments in the

rest of Asia do now seem to be trying to improve

matters.

For example, as recently as 2004, it took on

average the best part of half a year to start a

business in Indonesia. That is now down to a

couple of months. The improvements are less

dramatic elsewhere in the region, but you can see

from Chart 9 that these countries are all moving inthe right direction. Stronger investment should

follow which will bring down current account

surpluses. But, again, this is a process that will play

out over several years.

CHART 9:NO. OF DAYS NEEDED TO START A BUSINESS

0

30

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90

120

150

180

0

30

60

90

120

150

1802004 2010

Source World Bank

In the meantime, surpluses are already

reappearing. Just as with China, Koreas current

account surplus is now about as big in dollar terms

as it has ever been. (See Chart 10, on the following

page.)


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CHART 10:KOREA CURRENT ACCOUNT BALANCE

($BN,MONTHLY,SEAS.ADJ.)

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

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Korea illustrates the wider trend. And the country

also has its own symbolic significance as the chair

of the G20 the body that has been issuing clarion

calls for surplus nations to boost domestic

spending. Even if we are right to be more

optimistic about rebalancing in Asia outside China,

this will still take time.

Oil prices to fall, but not far enough

Moving on, the oil producers experienced thebiggest falls in surpluses last year because lower

demand for oil was compounded by a big drop in

prices. (See Chart 11.) The adjustment in prices

had the effect of redistributing income from

producers, who are big savers, to consumers who

tend to spend more of their income, so it boosted

demand at the global level. This suggests that a

prolonged period of low prices would be one way

in which the oil producers might be brought into

balance, thus helping the global recovery.

CHART 11:OIL PRICE &OIL PRODUCER SURPLUSES

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80

100

92 94 96 98 00 02 04 06 08 10 12

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0.8

1.0

1.2OPEC+Russia current accountsurplus (% world GDP, LHS)

Oil price ($pb, annual average,RHS)

F'cast

Sources IMF, Thomson Datastream, Capital Economics

Our central forecast is that oil prices will dropback to around $60 per barrel from todays $80 or

so and then stay there. This would take them back

to the levels before prices took off in 2007. But at

that level, the chart implies that the oil producers

would still have large surpluses.

A further fall to $40pb is possible if supply

improves more rapidly than anticipated. But as

Chart 11 suggests, oil prices would have to fall to

something like $20pb or below for the oil

producers surpluses to be brought into balance.That seems unlikely unless there is a collapse in

global demand. Any substantial fall in prices will

tend to feed demand and thus act as a stabilisation

mechanism. Even at the depths of the financial

crisis, the oil price remained well above $30pb.

Whats more, a sharp fall in commodity prices

would have some downsides. Headline inflation

would probably turn negative in the major

economies, raising the risk of a deflationary spiral.

Meanwhile, economies heavily dependent oncommodity exports would obviously suffer as well.

Will the oil producers start to spend?

Of course it is not out of the question that the oil

producers start to spend their income in a way that

they didnt over the last decade. For example, high

levels of unemployment in the Gulf region might

encourage governments to raise spending. Such a

shift would not be unprecedented. Oil producers

moved very rapidly from surplus to deficit in the

1970s.

But that experience ended badly with much

wasted investment and consumption that proved to

be unsustainable when prices dropped back.

Perhaps the strongest argument for oil producers to

save rather than spend oil proceeds is that the oil

wont last forever. It makes sense to save for the

days when it runs out.

In other words, oil producers have a much better

claim than Asian governments that surpluses are in

their peoples interests. For this reason we expectoil surpluses in general to remain high.


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The exception is perhaps Russia and there is agood chance that its surplus, which is about a fifth

of the oil producers total, will start to come down

and even shift into deficit in the next few years.

The key difference is that the vast bulk of last

years fiscal stimulus in Russia took the form of so-

called permanent measures such as increases to

state pensions and public sector wages. We

suspect that the Kremlin will find it hard to turn

back from these spending commitments. So unless

oil prices surge back towards $100pb, Russiasbudget deficit is here to stay and as the private

sector slowly starts to find its feet, the current

account will slip into negative territory too.

Russias exit from the worlds super savers will

have important implications locally. In particular,

the government will have to reform the business

environment and strengthen property rights if

Russia is to attract the capital the country needs to

develop. But it will not do much to help the world

economy we estimate the swing in Russiascurrent account balance over the next few years

will be equivalent to just 0.1% of world GDP.

So far, weve only discussed the oil producers.

Producers of other commodities tend not to have

large surpluses. Chart 12 shows all countries for

which non-fuel commodity exports are equivalent

to more than 20% of GDP. Not only are these

small economies were talking about places like

Malawi. But for producers of soft commodities and

metals, deficits are about as common as surpluses.

CHART 12:CURRENT ACCOUNT SURPLUSES OF NON-FUEL

COMMODITY PRODUCERS (%GDP)

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Countries with non-fuelcommodity exports > 20% of GDP

Sources UNCTAD, Capital Economics

In other words, shifts in the prices of non-oilcommodities do not in general have any impact on

global savings, they simply shift income from one

group of consumers to another.

Asia & the oil producers unlikely to boost demand

Bringing this together, we doubt that the developed

world will be able to rely on rebalancing in Asia or

among the commodity producers to boost demand

over the next few years.

In the end, it might be demographic change that

brings Chinas surplus down to earth. Thatinevitably means it will happen slowly. We are

more optimistic about the prospect for change

elsewhere in emerging Asia. But in the absence of

a very sharp drop in commodity prices, the

surpluses of the oil producing nations look here to

stay.

What about the rest of the emerging world?

One group of countries we have not mentioned so

far are those large emerging markets that dont

have big surpluses, places like Brazil and Mexico.Might these countries become a meaningful source

of global demand? To do so, they would have to

expand small deficits, rather than reduce large

surpluses, but other things being equal, the result

for the G7 would be just the same: smaller external

deficits and stronger growth. Whats more, there

are strong arguments from a domestic point of

view when you look at places like Brazil and

Mexico why these countries might want to run

bigger deficits in future.

Countries such as Mexico, Poland, Turkey and

Brazil all have huge investment needs. At present

investment is well below the 25% of GDP widely

considered to be the benchmark for emerging

economies and which most Asian emerging

economies easily surpass. (See Chart 13 on the

following page.) But at the same time, domestic

savings rates in these countries are low. As a result,

the pot of funds from which investment can be

financed domestically is much smaller than in the

likes of China and India.


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CHART 13:INVESTMENT (%GDP,2009)

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EM benchmark

Sources Thomson Datastream, Capital Economics

This leaves policymakers with two options. The

first is that they raise domestic savings. In fact, this

will probably happen over the next decade or so as

per capita incomes rise and recent improvements

to policymaking (notably a transition to inflation

targeting) gain traction. But this will be a gradual

process and a sizeable increase in savings is

unlikely without further reform, for example

limiting pension provisions, introducing forced

savings schemes or tightening fiscal policy.Unfortunately most of these measures would be

hugely unpopular.

This leaves the alternative of funding investment by

borrowing from overseas, in effect running current

account deficits that could at least in part offset the

surpluses of Asia and the oil producers. For some

emerging markets, then, the persistence of surplus

savings in other parts of the emerging world offers

a relatively painless way to finance a boom in

investment.

We think this shift is worth monitoring closely and

it has some interesting investment implications.

One is stronger emerging market growth in the

recipient countries as a pick-up in investment

pushes up the sustainable growth rate.

Bubbles inevitable in some emerging markets

But there is also the potential for greater volatility.

A reliance on external funding would make the

macro economy vulnerable to sudden shifts in

investor sentiment. Moreover, you only have tolook at the events of the past couple of years to see

how difficult it is for countries to regulate both the

quality and quantity of capital inflows. Rather thanbeing channelled into improving productive

capacity, there is a risk if these countries embrace

inflows from Asia that they inflate asset price

bubbles indeed this may already be happening.

House prices in parts of Brazil have surged

recently, while equity markets in some corners of

the emerging world such as Colombia are already

looking frothy. Capital controls are back on the

agenda, but must be complemented with further

macro-prudential measures to limit the damage tothe financial system and economy when bubbles

burst (as they inevitably will). The good news is

policymakers in most emerging economies are

aware of the risks. The bad news is that it is asking

an awful lot to expect that some of the more

sophisticated reforms that are necessary will be

implemented.

Can the G7 benefit?

How relevant is all of this to the developed world?

The initial assumption is that these economies inLatin America and Eastern Europe are too small to

substantially boost developed world exports. But

thats not really so, or at least not when you look at

them in aggregate.

CHART 14:GDP($TRN,2009)

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China OtherEm. Asia

Japan "DeficitEMs"*

US

* Deficit EMs = Brazil, Mexico,Turkey & Poland

Source IMF

Our potential emerging market deficit countries are

Brazil, Mexico, Turkey, Poland and a few smaller

nations in Eastern Europe and Latin America.

Together their GDP is not much smaller than

Chinas. (See Chart 14.) So we should not dismissthem out of hand. At the same time though, as long

as the surpluses of China and the oil producers


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remain high, the deficit emerging economies arenot large enough as a group to provide much of a

boost in demand to the developed world. The US

economy on its own is about four times their size.

Summary

In conclusion, we are confident that emerging

markets will continue to grow rapidly over the next

few years, but we do not believe this will be of

much benefit for the developed world. Asian and

oil producer surpluses look likely to stay high

unless China embraces structural reform muchfaster than seems likely or oil prices collapse. We

think that some emerging market deficit countries

could provide a degree of support to the developed

world. However, there are also risks. One is that

capital flows within the emerging world feed asset

price bubbles and raise macroeconomic

vulnerability indeed, this already seems to be

happening. Another is that our view on

rebalancing proves over-optimistic and that ratherthan broadly stabilising, the surpluses continue to

increase, in which case, the emerging world would

be a drag on developed economies.

Finally, there is the growing threat of

protectionism. A prolonged period of weak growth

and high unemployment in the West while

emerging markets are growing much faster is

potentially a volatile mix. The political cycles in

the US and China add to the dangers. The US

holds presidential elections in 2012. A newleadership will also take power in China in 2012.

In the meantime, the incumbent governments

capacity to push back against vested interests is

fading. It could easily all turn rather ugly. As long

as G7 economies are struggling, a lurch into

protectionism remains a major threat for the

emerging world.

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Emerging Markets Will Not Rescue the Rest of the World