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Economy in Brief

Emerging Market Challenges
by Andrew Cates  September 29, 2021

The outlook for many Emerging Market (EM) economies is becoming more challenging as fundamental factors that had been supporting economic growth are now moving into reverse. Those factors include:

• A slowing Chinese economy and its impact on world trade and commodity prices;

• Fading impulses from fiscal and monetary policy;

• A more hostile environment for global capital flows triggered by a likely tapering campaign from the US Fed; and

• A lingering disparity between COVID vaccination campaigns in developed and emerging economies.

On that last point, the success of those campaigns in developed markets is generating a shift away from consumer spending on goods and toward spending on domestic services which is derailing EM export growth. That lack of progress in vaccination campaigns in EM in the meantime is leaving domestic demand in those economies still-hostage to lockdowns and angst.

It is unsurprising against this backdrop that growth momentum in EM has cooled quite sharply in recent weeks. Incoming economic data have also elicited a much greater tendency to disappoint forecasters to the downside.

Which economies are most at risk? Cooling global growth momentum, tighter monetary policy and more unstable financial markets put economies that have been highly dependent on domestic credit and with large external financing needs at the same time most at risk. The good news though is that many EM economies have been chalking up current account surpluses in recent months and relatively few have been overly-dependent on private sector credit growth. That being said, Colombia, Chile and to a lesser extent Thailand and Indonesia are looking vulnerable, at least relative to other major EM economies.

In what follows we elaborate in more detail on some of these points with reference to a few data points and exhibits.

Cooling growth momentum

The first couple of exhibits in figures 1 and 2 below underscore the degree to which EM growth momentum has been cooling. The aggregate EM purchasing managers' index, for example, slipped well below 50 in August, the level that separates expansion from contraction. The Citigroup index of EM economic surprises has also just slipped into negative territory, signalling a far greater tendency of late for disappointment from incoming economic data.

Figure 1: Asia's PMI surveys suggest regional growth momentum is cooling

Figure 2: Incoming economic data in emerging countries is no longer surprising forecasters on the upside as frequently

COVID restraints are likely to persist

Some of this weakness can be traced to COVID and the delta variant in particular. But while case numbers in some EM countries have started to slow in recent days, it would be premature to assume that the worst of the pandemic is now over. Estimates of the so-called Reproduction rate remain above 1 for many large EM economies (see figure 3 below). Vaccination rates in the meantime are still very low (at least relative to most developed economies) amidst widespread reports of vaccine hesitancy (see figure 4).

Figure 3: Estimates of the COVID reproduction rate in many large EM countries are still above 1

Figure 4: Vaccination numbers in most large emerging countries have been quite low relative to developed economies

Source: University of Oxford/Haver Analytics

China could become a bigger source of instability

The outlook for China is also a big concern for the rest of EM. While the focus here has been on the financial difficulties of a big property company (i.e. Evergrande) the broader picture is worrisome. China's growth in general and its property market and infrastructure investment in particular have seen strong downward momentum in recent months. Aggregate building starts are already contracting and a recent tightening of credit could amplify the downward pressure on construction activity. Insofar as property construction and its adjacent industries in China account for about 25% of GDP, this could further dampen economic growth and generate more downward pressure on some commodity prices (see figures 5 and 6 below).

Figure 5: A negative credit impulse in China could imply more downside for some commodity prices in the period ahead

Figure 6: Aggregate building starts in China have slowed sharply in recent months

Fading policy support

Another generic reason for a cautious view toward many EM economies relates to the thrust from economic policy. While many EM policymakers responded to the crisis with a plethora of fiscal and (often unorthodox) monetary policy support measures, these are now shifting into a more restrictive zone. In the aggregate emerging economy universe, the IMF estimates that fiscal policy will be restrictive this year as well as in 2022 and 2023 (figure 7). The fiscal thrust is notably negative in China, Brazil, Russia and South Africa (among others) this year (figure 8).

Figure 7: Emerging economies will see a fading impulse from fiscal policy in the period ahead

Figure 8: Most major emerging market economies confront tighter fiscal policies this year

Source: IMF, Haver Analytics

Matters are not that promising on the monetary policy front either. Partly thanks to rising inflation (figure 9) and heightened concern that this might unhinge inflation expectations Central Banks in countries such as as Brazil, Mexico, Chile, Colombia, Peru, Russia, have all raised interest rates this year. Even as commodity prices possibly now roll over (in response to a slowing China), these Central Banks may not be that quick to reduce interest rates if their currencies were to come under more downward pressure.

Figure 9: Core inflation has climbed sharply in many emerging economies in recent months

Figure 10: Interest rates have risen in many emerging economies

Exposure to a more hostile capital flow environment

That brings us to the next source of downside risk, namely a US Fed that is readying financial markets for a prospective tapering of its asset purchases in the coming months. Longer-term US bond yields have climbed quite sharply in recent days in response to recent Fed communications on this matter. Insofar as this raises the US rates relative to elsewhere this could drive capital flows toward the US and away from EM. This more hostile environment for capital flows in turn could ignite financial instability in those countries that are highly dependent on external finance. EM crises in the past, after all, have typically been driven by this dependence particularly if it coincides with a heavy deployment of domestic leverage to support growth.

The good news here though is that many EM countries have been enjoying rapid export growth in recent months which has helped many to build up current account surpluses. At the same time as this, there aren't that many EM economies that are running large positive credit to GDP gaps that would signify a heavy dependence on domestic credit. As figure 11 below suggests, which shows the latest figures for current account balances relative to domestic credit to GDP gaps, only Columbia, Chile and to a lesser extent Thailand and Indonesia are in the “worrying” (south-east) corner. Still, those current account positions owe a great deal to vibrant world trade growth in recent months. That will almost certainly cool off now not least as China slows down and as domestic demand in developed economies tilts away from goods and toward domestic services.

Figure 11: Current account balance versus credit to GDP gaps

Source: IMF/BIS/Haver Analytics

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

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