Global: Putting the Risk Back into Emerging Markets
morganstanley.com
Stephen Roach (New York)
Needless to say, this has been a rough month for emerging markets. At its low on 13 June, the Morgan Stanley Emerging Markets equity index had fallen 25% from its 8 May high. Over the same period, spreads on a composite basket of emerging market debt have widened by about 45 basis points from their lows. Are these corrections mainly a market phenomenon, driven by a powerful risk-aversion trade, or are there more sinister forces at work?
For starters, context is key. While the corrections of the past month are serious by most standards, they barely make a dent in the generally outstanding performance of the emerging-market asset class over the past three years. For example, even after the May-June correction, emerging market equities are still more than double the averages prevailing in 2001-02. Similarly, composite debt spreads in the developing world of 230 bp are still only a little more than half the 430 bp norms of the preceding five years. The real question is not the correction but why these markets have gone almost straight up in the past several years. On the one hand, it is possible that emerging market securities have benefited largely from the combination of excess global liquidity and an increasingly urgent search for yield by fund managers. If that’s the case, and the liquidity cycle now turns, a sustained correction could well be in the offing. On the other hand, the true believers will tell you that something else has been going on -- a developing world that has finally broken its crisis-prone mindset of the past and now enjoys the best fundamentals in a generation. In that instance, any correction could be nothing more than a dip-buying opportunity.
While the point on liquidity is well taken, I would also stress that the second explanation is arguable. Yes, there can be no mistaking the progress developing economies have made since the Asian financial crisis of 1997-98. Battered by what then US Treasury Secretary Robert Rubin dubbed the worst capital markets upheaval in 60 years, emerging economies have unanimously vowed never again. On the surface, their post-1998 efforts have produced stunning results. Current account deficits, which amounted to -0.2% of developing world GDP in 1999, have given way to surpluses of 4.1% in 2005. At the same time, there has been a massive rebuilding of foreign exchange reserves. By our calculations, "excess" foreign exchange reserves in the developing world -- those above and beyond the outstanding volume of short-term external indebtedness -- have ballooned from only about $500 billion at the end of 1999 to more than $2.3 trillion in late 2005. For the most part, currency pegs have been dismantled and replaced with flexible foreign exchange regimes. And the developing world has sharply reduced its vulnerability to capital flight -- moving actively to cut exposure to the "hot money" of short-term capital inflows by replacing its external funding with more permanent sources of capital, such as foreign direct investment. Brazil, now the poster child of external debt reduction, is on a trajectory to eliminate its foreign indebtedness altogether within the next month or two -- an amazing transformation from the angst of January 2003, when the country’s net external indebtedness stood at $64 billion. In short, the developing world has certainly come a long way in repairing the damage that led to economic distress and humiliation in 1997-98.
Yet this is what I would call a classic example of the post-crisis response syndrome -- taking backward-looking actions that respond to the last crisis. The problem with this approach is that the proverbial next crisis is never like the last one. Economies, markets, policies, and institutions adapt continually to changing circumstances. New problems arise that old fixes are ill-designed to remedy. It’s happened time and time again in the developed, as well as the developing world. And as day follows night, there’s every reason to think that the next crisis in emerging-market economies will arise out of circumstances that will be very different than those that nearly brought the world to its knees in 1997-98.
At the top of my list is a possible capitulation of the American consumer -- long the most powerful engine on the demand side of the global economy. Such an outcome would strike at the heart of what I judge to be a still-chronic weakness in the developing world -- excess reliance on US-centric external demand. In large part, emerging-market economies have not succeeded in boosting internal consumption and, as a result, they remain heavily dependent on exports as the sustenance of growth. By our reckoning, exports were 38% of developing world GDP in 2005, well in excess of the 26% share in the developed world as a whole. Nor does this dependency seem likely to change in the immediate future. Based on the IMF’s latest forecasts, export gains in the developing world are expected to hold at 10.6% per annum over the 2006-07 period, well in excess of the 6.3% average pace expected for the more advanced industrial economies. Nor can there be any doubt as to the major end-market destination of developing world exports. In China, fully 40% of total exports go the US; moreover, US shares of total exports are 80% for Mexico, 23% for Brazil, 19% for Malaysia, 16% for Korea, and 16% for Taiwan. And, of course, there are also indirect linkages to the US -- namely, thorough an increasingly China-centric global supply that not only involves China’s Asian trading partners but also its materials suppliers in countries such as Brazil.
What this all means, of course, is that while the developing world has taken great steps to avoid the repetition of another financial crisis along the lines of the 1997-98 Asian crisis, it has done little to prepare itself for what could well be the next crisis -- a shortfall in its major source of external demand, the American consumer. We debate the US consumption outlook endlessly. With consumers refusing to flinch over the last few years, the bear case admittedly suffers from a major credibility problem. But now the stars are in especially tough alignment: A persistence of weak labor income generation, a faltering of the property-induced wealth effect, a sharp run-up in energy prices, negative personal saving rates, and mounting debt service burdens all point to a consolidation of discretionary consumption in late 2006 or early 2007. Should that, indeed, happen, externally-dependent developing economies that are heavily reliant on the US consumer could quickly be in trouble. The message from emerging-market equities is that investors are only starting to get a whiff of such a possibility. Interestingly enough, debt markets do not seem to have caught on to this possibility -- at least, not yet.
I’ve heard a lot in the past few years about the brave new world of emerging markets. I don’t doubt the extraordinary progress that has been made in many cases -- especially in the so-called BRIC economies of Brazil, Russia, India, and China. Nor can I minimize the post-Asian-crisis balance sheet repair undertaken by a host of other developing economies. But the outperformance of emerging market equities and debt seems to be discounting all that progress -- and then some. By fixing the problems that gave rise to the last crisis, developing countries have also been given generous credit for avoiding the inevitable next crisis. This is where I take issue with the markets and still overly-optimistic investors. Should the American consumer finally falter -- a development that I believe is increasingly likely -- a new vulnerability will arise that could prove quite challenging to the externally-dependent developing world. It would be a very different phenomenon than the shock of 1997-98, but it could end up being just as unsettling to emerging-market growth prospects.
The risk reduction trade of the past month has been a painful but welcome dose of realism for liquidity-driven financial markets. Commodities and emerging markets -- two of the riskiest of asset classes -- have suffered the most. While this has mainly been a capital markets event triggered by a rethinking of central bank policy expectations, there are some important fundamental risks that also need to be considered. Previously, I argued that a shift in Chinese commodity demand is one such possibility (see my 2 June dispatch, "A Commodity-Lite China"). Equally important, in my view, is to consider the possibility of a capitulation of the over-extended American consumer. Don’t get me wrong -- I would be the first to concede that neither of these outcomes is a certainty. But the bubble in risky assets was premised on an outright dismissal of these possibilities -- in effect, discounting the highly optimistic alternatives of open-ended Chinese commodity demand and an unstoppable American consumer. The recent risk aversion trade suggests the resumption of a two-way debate on both of these key issues. I view that as a welcome and healthy development. At long last, the risk is getting priced back into risky assets. I suspect this repricing has only just begun. |
