Emerging markets uncertainty

Last week Gavyn Davies reported in FT.com a summary of his debate on emerging markets with three prominent economists: Maurice Obstfeld (USC-Berkeley), Alan M. Taylor (UC-Davis), and Dominic Wilson (Co-Head of Global Economics, Goldman Sachs) – the “panel”. In summary (read full transcript here), the panel finds much vulnerability in the emerging markets (EMs). What’s more, any significant upset in the EMs might  backfire into developed markets (DMs) instabilities via external sector and commodity prices imbalances.

First, definitions: emerging markets – industry standard but an inconvenient term that is too generic and often misused. In the often used context EM best relates to countries with larger shares of their external sectors in GDP composition and those with relatively deep financial markets (e.g. see IIF’s January 2014 summary).

Second, the set up: many of the EMs are characterized (as also emphasized in the above mentioned panel) by: 1) overvalued FX rates (data showing currencies strengthening before and then immediately after 2008); 2) large current account surpluses (in most cases due to strong commodity demand); 3) strong domestic consumer demand and subsequently spending.

For the panel it means: expect a reversal once DMs recovery gains stronger momentum (see Dominic Wilson on the DM-EM balance, here). At the same time, should financial flows weaken and foreign exchange start leaving EMs are expected to rely on tighter monetary policy and foreign exchange reserves to defend domestic currencies, keeping a nominal inflation target in sight at the same time (e.g.).

But sustaining competitive FX rate is just one side of the story. The other is in the domestic consumer market, where overvalued FX has helped sustain consumer imports growth. More concerning are the significant rises in the domestic private credit shares across most of the EM economies. Alan M. Taylor offers a visual in this chart that tells the story (for more read AT’s comments in the full transcript here).

In terms of domestic credit, similar pattern emerges in the post-socialist former Soviet economies (FSU) – see the figure to the right showing domestic private credit as a share of GDP based on raw data from the WB’s World Development Indicators.



Domestic credit to private sector FSU, % of GDP

The chart compares average credit shares between two periods: 2000-2008 and 2009-2012. For most countries, relative macroeconomic stabilization that followed rockier (pardon the term) 1990s has coincided with an increase in credit shares as financialization of these economies continues. Much of that has seen introduction of new financial services and growth of the banking sector.

Yet, it remains to be seen if the current high credit shares, as shown here, are in fact sustainable and not driven by speculative financial intermediation. In case of the latter, any sudden FX outflow on a significant scale would potentially worsen the prospects for domestic financial market leading, in extreme case scenario, to a credit crunch. This might be likely as much of the domestic credit activity is driven by the local banks having access to and ability to borrow on short-term in foreign currency (e.g. here on Russia). That ability was in turn (as per the panel) has been spurred by the DM’s quantitive easing policies elsewhere.

Uncertainty permeates these scenarios with more dynamic determinants than first meets the eye. On an analytical level some of these factors are conceptualized here, as redefined fundamental uncertainty in the global financial markets.

And  though EMs are in better shape (largely thanks to FX reserves accumulation & commodity prices, especially for the larger economies) than in the 1990s (as noted in Mr. Davies’s panel) both monetary and fiscal authorities in the EMs should keep an eye on speculative consumer credit growth in the backdrop of strong FX under managed float. That seems to be relevant for any qualifying EMs, definitions notwithstanding.