By Stephen Jen (via Itau Global Connections).
Bottom line: We continue to believe that the BRL, TRY, ZAR, INR and IDR will likely resume their depreciation and the dollar will likely set new highs against them in the coming months. In this note, we make the point that there are strong parallels between these EM economies and the European peripheral countries, that all of them suffer from the problem of being unable to efficiently digest lumpy inflows of cheap foreign capital. Whatever the motivations for the capital inflows, the end result in both cases was a strong surge in private domestic credit, which in turn was used to finance consumption rather than investment, fuelling services rather than manufacturing. When the liquidity tide receded from peripheral Europe, the domestic credit cycle in these countries turned and exposed the structural flaws of the economy. Macroeconomic pressures have persisted in these countries to wring out the distortions that had led to the external imbalances. Specifically, over the last three years, output contractions (by around 7 percent of GDP) and rising unemployment (from 7 to 19 percent) were necessary to bring the collective external balance of the peripheral European countries back into balance. We believe many of these EM economies will likely go through a similar experience. The key difference between the two cases is that the EM countries have currency flexibility, which we believe will be fully utilized to vent the macro pressures. The currency depreciations that have taken place thus far are highly insufficient, and we will also need to see a substantial compression in domestic demand for external balance to be achieved.
The basic story of peripheral Europe. The European Crisis began with Greece revealing in late-2009 that it had falsified its fiscal accounting and that the actual fiscal figures were substantially worse. However, the subsequent crises experienced by Ireland, Portugal, Spain and Italy were not triggered by imprudent fiscal practices but more due to problems of a monetary nature: interest rates were simply too low. It may be useful to remind ourselves that the borrowing costs these countries faced prior to 1999 were substantially higher: the 10-year government bond yields reached 10%-12% in both Spain and Italy in the mid-1990s but fell sharply to 5%-6% by 1999 when they joined the EMU. Importantly, after they joined the EMU, the interest rates in Europe did not only converge toward the average, but they converged toward the German levels.
These capital flows have had several detrimental effects on the recipient countries. First, a low-interest rate environment encouraged consumption and discouraged savings. (This is very different from what happened in China, where a low interest rate environment, coupled with other distortions, actually led to a rise in savings and high investment.) Second, this increase in consumption led to a rise in demand for services as well as a rise in demand for tradable goods (imports). As a result, there was a shift in resource allocation from the more productive manufacturing sector to the less productive services sector, especially construction. This was especially the case in Ireland and Spain.
Before the onset of the crises, the macroeconomic variables in these European peripheral countries looked great. But as soon as the tide of cheap foreign liquidity receded, the ugly reality was revealed. There has been much talk about the importance of fiscal prudence in Europe. The reality is that, prior to the crisis, Spain’s fiscal statistics were better than those in Germany. For example, in 2007, Spain’s stock of public debt was below 40% of its GDP, compared with 65% in Germany. Spain ran fiscal surpluses in the years leading up to 2008, compared with fiscal deficits in Germany. In fact, the cumulative fiscal surplus in Spain during 2005-07 was 5% of GDP, compared with 5% of GDP worth of fiscal deficits in Germany. But when the foreign liquidity receded, exposing the problems in the Spanish economy through the faltering banks and the deflating property markets, Spain’s public debt position deteriorated sharply. In any case, what now looks like a fiscal problem in most of these peripheral European countries was in fact a monetary problem.
This process of cheap foreign liquidity creating lasting damage for the economy of the recipient country is sometimes referred to as the ‘financial resource curse.’ Similar to the literature on the ‘resource curse’ – which is about how countries endowed with rich natural resources tend to have low economic growth rate and inferior social measures (such as education, equality, etc.), cheap capital inflows, if not properly digested, can create serious macroeconomic problems. Worries about how cheap capital inflows distort the economy are also one justification for capital controls.
This story applies to some EM countries as well. We argue that there are strong parallels in some EM countries today. Cheap and lumpy capital inflows were not very well processed or utilized in some EM economies, in much the same way that they were not well processed in the peripheral European countries. Some countries ‘deserve’ to have high risk premiums to ensure proper pricing of liquidity and credit, corresponding to the underlying structural fundamentals (economic, political, social and otherwise) of the economies in question. But when these risk premia are compressed excessively, misallocation of resources ensues and, if this situation is sustained, macro imbalances grow until a breaking point is reached or until there is a ‘sudden stop’ in capital inflows for whatever the reason.
In the chart below (please see the attached pdf), we show the average profile of selected peripheral European economies and some EM countries (with the timeline for the latter lagged by five years).
The blue solid line represents the European countries. As soon as these economies joined the EMU in 1999, they began running ever-larger CA deficits, reaching a collective 8.4% of GDP by 2008. Since then, Italy, Spain and Portugal have experienced a cumulative 7% of GDP contraction, and their collective unemployment rate surged from 7% to 19% during this period. It was through this severe compression of domestic demand that these economies were able to regain a balanced external balance.
The dotted red line in the chart above denotes the CA balance of selected EM economies. They have been running ever-growing CA deficits since 2008, with the collective CA deficit approaching 6% of GDP by early-2013. (We underscore here that, since 2008, peripheral Europe experienced a sharp improvement in its external balance, while the EM countries experienced an exactly opposite trend.) Part of this was due to commodity exports from these EM economies being weak, due to weak demand in DM. But the main part of this deteriorating external balance was due to unrestrained consumption as the DM central banks exported extraordinarily cheap liquidity.
Some have argued that, with the currency depreciation in May-June, the likes of India, Indonesia and Turkey should be able to see their external imbalances shrink. We seriously doubt that. To achieve a sharp compression in the CA deficits, substantial contractions in these economies will be required, in conjunction with further currency weakness.
The second parallel between these EM economies and the problematic European countries is that their domestic credit cycles trended with capital inflows. The chart on the left above shows the level of credit to the private, non-financial sector. The blue line is for Europe. One can see the dramatic rise from 1999 to 2008, from 100% of GDP in 1999 to 230% by 2008.
In comparison, the level of credit, in percent of GDP, has not been as high for the selected EM countries. However, as the chart on the right above shows, the growth rate of this credit has been substantially higher than that in Europe (the gray line in this chart, compared with the blue line).
While we are looking at this chart on the right, we make one interesting observation. Around 2008, we saw diametrically different credit policies in China and in the other EM economies. In China (the red dotted line), we saw in 2008-09 a surge in credit growth from around zero to more than 20%, as it was the explicit policy of Beijing to respond to the global crisis through massive credit expansions. In contrast, in the other EM economies, domestic credit suffered a sharp slowdown as capital inflows were temporarily interrupted. Another feature in this chart that is worth remarking on is that, since 2009, when the Fed began conducting QE operations, both China and the other EM economies saw healthy growth in their domestic credit.
One lesson from the European Crisis is that when foreign capital receded, so did domestic credit growth. Credit growth has flat-lined since the onset of the European Crisis in 2010 and has actually begun to contract in percent of GDP. In the EM countries, we will likely see a similar deceleration in the growth rate of credit (in percent of GDP), we predict. While the absolute levels of domestic credit may not be that high, the rapid growth rate of this credit in recent years likely suggests that there’s been a problem of misallocation of credit.
The Fed and the EM currencies. A dovish Fed that tries to postpone the timing of QE tapering may buy some time for these EM countries, but it is unclear what could be done to avoid further currency depreciation or economic slowdown whenever the Fed starts to normalize its policies. One could even argue that the longer the Fed waits before tapering, the greater the distortions in the EM economies and the bigger the adjustments when the time comes. At the same time, even if the Fed does not taper, continued stabilization in Europe could also be a trigger for capital outflows from EM.
De-rating of EM. We continue to believe that investors have been overly optimistic on the long-term growth prospect of many EM economies. The 2000s were an extraordinary period that will not likely be repeated. Sustained economic growth requires not only a healthy and growing population, but also a prudent marriage of capital with labor, as well as consistent total productivity growth. In our previous work, we pointed out that many EM economies generated their outsized economic growth in the last decade from consumption rather than investment, and from services rather than manufacturing, and they did so with a low urbanization rate and low TFP growth. Extrapolating from the growth performance of the 2000s to come up with long-term forecasts of what these economies are capable of, without taking into account the toxic compositions of growth, will likely prove to be misleading. We maintain our view that a significant de-rating of EM will need to take place at some point and will probably coincide with the next major EM sell-off.
Bottom line. What happened to the EM currencies in May-June was not just a bad dream. It was a precursor to what will happen in the coming months, in our view. A dovish Fed led by Ms. Yellen and other problems in the US may temporarily weigh on the dollar. But as long as the U.S. economy continues to recover, the Fed will not be able to prevent an adjustment in some of these EM economies. We see close parallels between the savings-deficit EM economies and the peripheral European countries. The sole difference between the two is that EM currencies are flexible. A compression in the collective CA deficit will likely entail substantial further currency depreciation as well as a period of sub-trend economic growth. The prevailing view seems still to be too sanguine on these EM currencies.
Some additional considerations on international capital flows
Issue 1: Capital flows into higher-yielding economies have surged to unprecedented levels. In the two decades before the turn of the century, around USD 2.5 trillion flowed into emerging market economies. Since 2000, the magnitude of these flows has more than tripled, to USD 8.5 trillion. Even adjusting for economic growth of the recipient countries, the values are still extraordinary: capital flows into EM, which averaged less than 2% of GDP before the mid-1990s, surged to around 5% of GDP in the most recent years. These movements, which supported high levels of consumption in countries like Brazil, Turkey and South Africa, have contributed to the heating up of sectors like housing and services and have induced a shift in the production structure of the economy away from the tradable sector.
Issue 2: This unprecedented magnitude of capital flows into EM still lags behind those observed in Europe. Between 2003 and 2013, Brazil, Turkey and India received close to USD 7 trillion in foreign capital, or around 44% of GDP. In contrast, data on international investment positions suggest that some southern European economies received more than 100% of GDP worth of foreign capital in the decade between 1998 and 2008, as large volumes of capital flowed from northern European countries into higher-yielding economies, such as Greece, Portugal and Spain. We believe the elimination of currency risk and the reduction in the perception of credit risk implicit in the common currency area exacerbated ‘pull’ forces on foreign capital in the ‘peripheral’ countries of Europe.
Stephen Jen is the managing partner at SLJ Macro Partners. Prior to establishing SLJ Macro Partners in April 2011, Stephen was a Managing Director at BlueGold Capital (since May 2009), working as the key risk-taker in currencies and as its macro strategist. Before BlueGold, Stephen was a Managing Director at Morgan Stanley and, from October 1996 to April 2009, held various roles, including the Global Head of Currency Research and the Chief Global Foreign Exchange and Emerging Markets Strategist. Prior to Morgan Stanley, Stephen spent four years as an economist with the International Monetary Fund (IMF) in Washington, D.C., covering economies in Eastern Europe and Asia. In addition, Stephen was actively involved in the design of the IMF’s framework for providing debt relief to highly indebted countries. Stephen holds a PhD in Economics from the Massachusetts Institute of Technology, with concentrations in International Economics and Monetary Economics. He also earned a BSc in Electrical Engineering (summa cum laude) from the University of California at Irvine. Stephen was born in Taipei, Taiwan, and now lives in London with his wife and two children.