Sunday, September 30, 2012

Deflating the emerging markets bubble

Ryutaro Kono of BNP Paribas recently wrote an excellent piece discussing the bubble that was built in emerging market economies (EMEs) which is in the process of deflating. The thesis is simple: EMEs historical growth is unsustainable and these nations are undergoing a tremendous structural (as opposed to a cyclical) adjustment. The current slowdown (see chart below) is the result of the "stripping away" the post-crisis stimulus.

GDP YoY (source: BNP Paribas)

Monetary easing in the US had a direct impact on monetary policy in emerging markets. It works by weakening the US dollar which puts upward pressure on EMEs' currencies. These nations' central banks try to maintain a peg (implicit or explicit) to the dollar to defend their exports' competitiveness. To do so the central banks must buy dollars and sell ("print") their domestic currency. That ends up boosting foreign reserves and increasing the monetary base, creating an extremely easy domestic monetary policy.

Foreign exchange reserves  (source: BNP Paribas)

Such accommodative policy combined with infrastructure and other government spending generated unsustainable growth that is currently being reversed.
BNP Paribas: - The direct cause of the slowdown that began last spring by three big EMEs— China, Brazil and India — was the stripping away of the effects of the massive fiscal stimulus adopted in 2009. For instance, China’s fiscal stimulus package was massive at RMB 4 trillion (13% of GDP), and this made China the global economy’s growth engine following the Lehman shock. What is more, monetary conditions were also made extremely accommodative. Specifically, the aggressive easing by the Fed (QE1 and QE2) spilled over into the EMEs via their exchange rates. The mechanism involved worked like this: Because the Fed’s aggressive easing resulted in the weakening of the dollar, EMEs had to undertake dollar-buying intervention in the FX market to neutralize upward pressures on the local currency, something that made domestic monetary conditions extremely accommodative. Thus, the robust growth by the EMEs these past three years was inflated by the aggressive monetary/fiscal policies, and so was unsustainable.
Of course EMEs' growth prior to to the financial crisis was not sustainable either because it was driven by the credit bubbles in the US and the EU.
BNP Paribas: - Because the EME boomed both before and after the Lehman shock, the impression has taken root that the EMEs are the global economy’s driver. But the robust EME growth prior to the Lehman shock was also not sustainable. In retrospect, we can see that that brisk EME expansion was made possible by an export boom that was fueled by the bubble-driven economies of Europe and America. That China became the world’s production hub is due not just to its strong competitiveness but also to the voracious demand from the US and Europe. 
This of course does not bode well for global growth in the coming years.
BNP Paribas: - At long last, the process of undoing this bubble seems to have started. Now if my supposition about an EME bubble is correct, the big three EMEs will continue to slow for a while, and even if a cyclical recovery kicks in, returning to the former robust growth rates will be hard. That is why we cannot expect the global economy to pick up the pace for the time being
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