What happened to the emerging markets dream?

Tristan Hanson, Head of Asset Allocation at Ashburton Investments.

Emerging markets, once viewed with so much optimism, are now at the point of widespread pessimism.

Tristan Hanson, Head of Asset Allocation at Ashburton Investments, reflects on the reasons behind this and what the future holds for these economies.

One does not have to look back far to find a time of unbridled optimism for emerging markets. Unprecedented GDP growth rates, vast foreign exchange reserves, a rapidly growing middle class and a host of other arguments were used to explain why emerging markets would both drive global growth and offer the most exciting opportunities for investors. There would be ‘decoupling’ as emerging markets would weather whatever crises occurred in the West. And there would be ‘convergence’ as low and middle income countries caught up with the world’s richest nations. Books such as When China Rules the World (2009) or The Emerging Markets Century (2007) captured the zeitgeist.

How different things seem today, a time of widespread pessimism about prospects facing these same countries. EM growth rates are down, their currencies have plummeted and emerging market equities have been a great disappointment - essentially flat over the past five years (+5% in USD terms1) during which time developed market equities have gained nearly 80%. With the exception of India, where the consensus view remains optimistic, it is hard these days to find someone with a positive outlook on growth prospects in the other BRICS nations – Brazil, Russia, China and South Africa.

So what happened to the emerging markets dream? What did the optimists miss? And what might the future hold?

To begin to address these questions, we need to consider both the nature of economic growth and events dating back to the 1990s that have shaped the emerging world.

The nature of economic growth

Very simply, growth in economic output is achieved by increasing the inputs (labour, capital, human capital) and getting more out of them (productivity). Population growth, capital deepening, better education and skills, new ways of doing things and re-allocating resources to more productive activities are what drive higher economic output. Having more inputs, by saving and investing, and using them better are the proximate determinants of growth2.

However, every decision taken by businesses, government or households is embedded in a deeper determinant of growth, loosely termed in the academic literature as ‘institutions’3.

‘Institutions’ encapsulates factors such as the nature of property rights, rule of law, control of corruption, the quality of regulation, labour institutions, macroeconomic policy and numerous other influences which affect the incentives people face and therefore the decisions they make.

When one thinks about the nature of growth in this way, it quickly becomes clear that microeconomic and institutional foundations play a much greater role in determining long run growth than macroeconomic policy. Of course, countries cannot thrive without sound macroeconomic management – sustainable public debt and moderate inflation, for example – but good macro policies in themselves are insufficient to create high growth for prolonged periods lasting a decade or more.

From crisis to euphoria: 1994-2008

Before the exuberance of the late noughties, the 1990s was littered with major crises in emerging markets: Mexico (’94), Asia (‘97/98), Russia (’98), Brazil (‘98/’99), Turkey (‘01) and Argentina (‘01/02) the most notable. The prolonged weakness in emerging market equities was only one symptom of the turmoil - it took 11 years to regain the 1994 highs in US dollar terms.

But these crises set the conditions for the boom which was to follow. Extremely depressed exchange rates (which became a policy goal via persistent central bank currency intervention) and higher savings rates provided the basis for current account surpluses. Macroeconomic policy became much more orthodox: governments tightened their belts and inflation targeting caught on, as it had in developed countries. Macroeconomic resilience was achieved.

As globalisation accelerated, China’s enormous economic success and its sheer scale fuelled a commodity super cycle4, benefiting producers in much of the emerging world. The result was a golden era for emerging markets collectively. Between 2001 and 2008, emerging economies grew at an average annual rate of 6.6% compared to 3.7% over the previous twenty years.

Extrapolation

The mistake of many analysts – and governments - was to extrapolate this success, rather than recognise it as a uniquely positive period for emerging countries. Some reversion to the mean was more likely; clearer still with hindsight.

Meanwhile, credit booms in several countries, most notably China, began to create their own vulnerabilities. As events have since made clear, hubristic and complacent policy in the good years left certain economies poorly equipped to sustain growth once the tide of rising commodity prices went out.

To a large degree, the problems in China today are the unfortunate consequence of the policy response to the 2008 Global Financial Crisis. Faced with collapse in the US and Europe, Chinese policymakers dragged up the rest of the world with an enormous stimulus programme, increasing domestic credit by more than twenty percentage points of GDP in 2009 alone.

Inevitably, the massive credit boom has come home to roost as the authorities try to deal with the fallout of bad loans in the infrastructure and property sectors, as well as corruption among Party officials. And this has all occurred at a time when China is ageing rapidly which will itself cause growth to slow further in the years to come.

Not the 1990s

The silver lining to the cloud overhead is that fixed exchange rates are mostly consigned to history. In years gone by, pressure on capital flows would sharply tighten monetary conditions, forcing a severe contraction and probably a banking crisis. Today, in most countries, the exchange rate takes most of the strain, lessening the impact on the real economy.

Moreover, despite some deterioration, macro imbalances are generally not as large as twenty years ago and inflation remains low in most countries. The latter point is important, as low inflation allows greater policy flexibility.

Ultimately, a sufficiently large currency depreciation should create a boost to output via a rising trade balance, although the depreciation required will depend on the extent of the collapse in a given country’s export prices.

A challenging road ahead

As with much else, discussion of the outlook must start with China.

It seems inevitable that Chinese growth will slow substantially in the future, the real question is whether it does so smoothly or in a chaotic manner. While China still has much room to catch up with the richest countries, the country faces some considerable headwinds: an unbalanced economic structure, a shrinking working-age population of workers and the challenge of institutional and political reform. China might continue to grow faster than many countries in the decade to come, but its growth rate will be lower than in the recent past.

The fate of China and of the developed world will determine the external environment facing other emerging countries. In turn, how each country fares will depend on the policies their own governments choose.

Consideration of what drives growth over the long-run makes it clear that assuming all emerging markets are alike is a mistake. As Harvard’s Dani Rodrik puts it, “The real lesson from the collapse of the emerging-market hype is the need to pay closer attention to growth fundamentals and to recognize the diversity of circumstances among a group of economies needlessly lumped together”.

To sustain robust long-term growth, policymakers in many emerging countries need to improve the economic environment for businesses and households to thrive; whether that be through better education, more competition, improved regulation or any host of possible policy areas. Circumstances will differ by country.

We are hopeful that bright spots such as India or Mexico can reap the benefits of positive reform. India, in particular, merits attention because of its size – on a PPP5 basis it is already the world’s third largest economy. A young and growing population, improved macro policymaking and a reform-minded government should give India a better chance than most.

Weak exchange rates or a cyclical global pick-up may provide a short-term stimulus, but countries unable to generate policies that encourage investment and entrepreneurial activity will face mediocre long-term growth at best, punctuated by crises.

One concern for the long-run outlook noted by Rodrik (20156) is the premature deindustrialisation of a number of developing countries. Each of the growth miracles in East Asia relied on shifting the economy towards manufacturing. Therefore, the decline of manufacturing’s share of output in many countries either suggests a new path to rapid growth must be found or that growth miracles will be harder to come by.

Conclusion

Emerging market optimism has come full circle to the point of widespread pessimism. The good news this time around is that floating exchange rates provide much more of a buffer in contrast to the 1990s. That might seem little comfort to GEM investors at present, but it will be for many citizens.

In the near-term, much rests on what happens in China. In the long-run, for most countries it will be the environment policymakers create that will determine economic success. On that front, there is at least much room for improvement, although whether the opportunity will be taken is not clear in many cases.