An excerpt from Morgan Stanley’s June 27 report “The Global Macro Analyst.”
Economic growth in many emerging economies has slowed sharply over the past year. To some extent this is cyclical: EM central banks had tightened monetary policy to quell inflation; the slowdown in the advanced economies has taken its toll; and global risk-aversion on the back of the euro debt crisis has led to reduced external funding. However, there is a deeper structural issue that is now being exposed: the traditional EM growth model is broken and the transition to a new model – a rebalancing of EM economies – isn’t going anywhere. Policy stimulus as it is now being applied by central banks and governments may help to paper over the cracks for a while and should provide a short-term boost to demand. Yet, a successful switch towards a new growth model requires serious structural reforms. Should EM policy-makers take growth for granted and ignore the need for change, we believe that their complacency could put both EM and global growth at risk.
Why is the EM growth model broken? There are both external and internal reasons. For starters, the external environment is nothing like it used to be before the credit bubble in the advanced economies burst four years ago:
– The global financial crisis and the ensuing recession delivered a brutal shock to DM consumption and thus to EM exports. And the triple B recovery in the advanced economies that has unfolded ever since confirms that exports to DM economies can no longer be the primary driver of EM growth.
– EM exporters are facing new competitors thanks to a resurgence of DM manufacturing and ‘onshoring’ of production. Over the better part of a decade, EM economies have seen their competitive advantage being steadily eroded due to a combination of strong wage increases and nominal exchange rate appreciation (see Exhibit 1). The beneficiary of this zero-sum game is DM manufacturing. With its enhanced competitiveness, DM manufacturing can cater to domestic demand in the DM and even the EM world.
– EM growth is at risk because ongoing financial sector deleveraging and high sovereign funding needs in the advanced economies imply that external financing for EM countries has become less readily available. Current account surplus and deficit countries alike depend on international funding markets to roll over public and private liabilities. The prominent case of India, where the current account deficit has become increasingly difficult to fund amid capital outflows, raises concerns for other funding-constrained economies (particularly Turkey, Hungary and Indonesia). Should domestic growth falter, investors would likely worry about a negative feedback loop developing there too.
Turning to the internal impediments to EM growth, the reliance on export-led growth has meant the neglect of the ‘right kind’ of domestic demand in many countries.
In the case of China, the ‘subsidy’ of cheap and abundant capital flowing into the export sector and infrastructure spending directed towards ports and distribution networks has been granted at the expense of developing a better social safety net for households. This has effectively prevented the emergence of consumption as a viable driver of growth as Chinese households have to rely on private savings to be prepared for a rainy day. In India, consumption is abundant but the economy is sorely lacking infrastructure and particularly private investment, which fell during the financial crisis and has remained subdued even today. Thanks to uncertainty of external demand facing China and the more certain constraints on government-led consumption in India, these incumbent strategies are facing diminishing returns. Handing over the drivers of growth to consumption and investment in China and India respectively is therefore a must in order to produce higher potential growth in the medium term.
Moreover, China, as a downstream export portal for the EM world, has allowed many EM economies to simply specialise in the export of those raw materials (from commodity exporters in LatAm, Asia and CEEMEA) or semi-finished goods (mostly from other Asian economies) that feed into the Chinese manufacturing machine. This is David Ricardo’s principle of ‘comparative advantage’ applied on a scale that even Ricardo himself might not have anticipated.
For commodity exporters in particular, this specialisation has come at the cost of competitiveness of non-commodity sectors, i.e., an onset of the ‘Dutch Disease’, from Indonesia to Brazil. Thanks to the spectacular increase in commodity prices, the increasing investment in the commodity sector has drawn in more and more capital and labour, raising the prices of these factors of production. Quite naturally, other sectors of the economy have struggled to stay competitive. Add to this the decline in competitiveness caused by currency appreciation and it is quite easy to see how a two-track economy has developed across the commodity-exporting world. As if this wasn’t enough, Brazil’s unnaturally high real interest rates create a further burden on the struggling non-commodity manufacturing sector.
Rather surprisingly, there is one part of the world that may not have to make dramatic changes to its export-led structure. Even more surprisingly, this part of the world is a subset of CEEMEA economies. Why? 32% of exports from the Czech Republic went to Germany in 2011, as did 27% of Polish exports and 25% of Hungarian exports. If Germany is set to learn to love inflation (see Sunday Start, April 15, 2012), then we believe that it will be because negative real rates there are likely to set off a consumer boom. In turn, this should translate into more support for exports from these economies than most investors expect. Because we are short-term bearish and longer-term constructive on the future of the eurozone, this tailwind may not be apparent yet, but it will manifest itself slowly, in our view.
Transitioning to the ‘new’ model will likely take time: The ‘new’ growth model requires that EM economies take a step back from Ricardian comparative advantage and generate sustainable domestic demand at home. This new model cannot be created overnight. We believe that abandoning the export/investment-led strategy altogether would lead to a collapse in growth in the near term that would be disastrous both economically and politically. At best, EM economies will therefore move only slowly away from their old growth model.
At a time when growth is subdued, such a slow withdrawal implies that new growth strategies cannot be introduced very rapidly. China’s consumption story, India’s investment and infrastructure needs and competitiveness for Brazil’s non-commodity sectors are likely to be addressed over a matter of years, not months.
The ‘wrong’ kind of policy stimulus could make imbalances worse: Policy easing could certainly help growth. However, even here, policy-makers will need to tread carefully, in our view. Attempts to restore growth to pre-crisis levels or thereabouts will most likely backfire (after an initial boost), given that potential output is now lower globally. More importantly, simply conducting broad-based easing will likely spur the ‘wrong’ kind of domestic demand. Should such easing lead to even more export-oriented investment in China, consumption in India and more commodity sector investment in Brazil and other commodity producers, we believe that it is only a matter of time before growth runs out of steam.
We only have to look back over the last few years to see how that would work. Over 2009-10, aggressive easing saw credit-induced investment go through the roof in China while fiscally sponsored consumption made investors in India ask “what recession?” In Brazil, a recent BNDES survey showed that over 50% of new investment (excluding supporting infrastructure) was concentrated in the commodity sector. Propelled with great vigour just a few years ago, these growth strategies have already run their course.
The world is going through a ‘demand shortage’. Domestic demand is sluggish in DM economies and external demand is thus weak for EM economies. The ‘natural’ solution would appear to be to encourage EM domestic demand. However, this view isn’t nuanced enough, in our opinion. Our argument above suggests that addressing this demand shortage by stimulating just any type of domestic demand in the EM world will not work. Rather, it is the ‘right’ kind of domestic demand that needs to be encouraged. This is a significantly harder task, and one that will likely take more time.
All is certainly not lost for the EM world: The source of EM growth outperformance has been the improvement in socio-economic development over the last few decades (see Exhibit 3). As long as EM economies continue to ‘catch up’ with the DM world in terms of standards of living, EM productivity and potential output growth should continue to outperform. However, a more sustainable growth model over the medium term is required to ‘finance’ these socio-economic improvements. How policy-makers react over the next 6-12 months will give us strong clues about the progress towards a ‘new’ growth model. Should they continue to take growth for granted and cling to the old model, we believe that EM and global growth would both be at risk.
Source: Morgan Stanley (Manoj Pradhan, Joachim Fels)