Emerging Markets and disinflation in developed economies


Macro Letter – No 5 –14-02-2014
Emerging Markets and disinflation in developed economies


Emerging markets have become the focus of attention since the beginning of the year. Many articles have appeared anticipating a repeat of the 1997 Asian crisis but I believe the effects of globalisation and the low levels of inflation in the developed world mean that though a broad crisis might ensue it is more likely that a major crisis will be averted, at least for the present.

Since the second half of 2013 one of the greatest risks to a sustained economic recovery in the developed economies has been the stability of emerging markets. Last year concerns began to emerge with a collapse in the INR, but soon spread to other emerging market currencies. This led a number of commentators to identify the “Fragile Five”; Brazil, India, Indonesia, South Africa, Turkey. The basis for this epithet was: –

1. Twin budget and current account deficits
2. Falling growth
3. Above target inflation
4. Some form of political uncertainty

Further candidates for inclusion based on political factors include: Argentina, Hungary, Thailand, Ukraine and Venezuela – the “Vulnerable Five”.
In this letter I want to look at emerging markets in general. To begin it is worth reviewing world economic growth over the past two decades and forecasts for the next few years. Below is a table of GDP Growth extracted from the IMF World Economic Outlook – October 2013:-

GDP growth              Average                                                                                           Projections
Year                              1995–2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2018
World                                  3.6         4.7      5.2     5.3      2.7   –0.4  5.2     3.9    3.2     2.9     3.6    4.1
Advanced Economies      2.8         2.8      3.0    2.7      0.1    –3.4  3.0     1.7     1.5     1.2      2.0   2.5
Central/East Europe        4.0         5.9      6.4    5.4      3.2   –3.6  4.6     5.4     1.4     2.3     2.7    3.7
CIS                                       2.9         6.7       8.8   8.9      5.3   –6.4  4.9     4.8     3.4     2.1     3.4    3.7
Developing Asia                7.1          9.5      10.3  11.5     7.3      7.7   9.8     7.8     6.4    6.3     6.5    6.7
Lat Am and Caribbean    2.5          4.7       5.6    5.7      4.2  –1.2    6.0     4.6     2.9    2.7     3.1    3.7
MENA                                 4.6          5.5       6.8   5.9      5.0     3.0   5.5      3.9     4.6    2.1     3.8   4.4
Sub-Saharan Africa          4.5          6.3       6.4   7.1       5.7     2.6   5.6      5.5     4.9    5.0     6.0   5.7

Source: IMF

Perhaps a more useful guide to GDP is to be found in the deflated Real GDP data – again extracted from IMF WEO – October 2013: –

Real GDP data         Average                                                                                          Projections
Year                             1995–2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2018
Advanced Economies      2.8          2.8      3.0     2.7     0.1    –3.4   3.0     1.7    1.5    1.2     2.0      2.5
Central/East Europe       4.0          5.9      6.4      5.4     3.2    –3.6   4.6     5.4   1.4    2.3    2.7      3.7
CIS                                      2.9           6.7      8.8     8.9     5.3     –6.4  4.9     4.8   3.4    2.1    3.4      3.7
Developing Asia               7.1           9.5     10.3    11.5    7.3        7.7   9.8     7.8   6.4   6.3    6.5      6.7
Lat Am and Caribbean   2.5           4.7      5.6      5.7     4.2    –1.2    6.0     4.6   2.9   2.7    3.1      3.7
MENA*                              4.6          6.0      6.7      5.9     5.0      2.8    5.2     3.9    4.6   2.3    3.6     4.4
Sub-Saharan Africa         4.5          6.3      6.4      7.1      5.7      2.6    5.6     5.5    4.9    5.0    6.0    5.7

Source: IMF

*MENA includes Afghanistan and Pakistan

This analysis suggests that developing Asia will continue to lead the way followed by MENA and the frontier markets of Africa. Whilst this may be useful for tactical asset allocation it tells us little about the size of the economies in question.

To address this issue I’ve ranked the emerging markets from the latest World Bank – GDP data 2012. It is these largest emerging economies that will have the greatest international impact. Here are the EM’s taken from the top 30. As you might expect, the BRIC’s are at the top: –

Gross domestic product 2012

Economy                        Mlns US dollars
2 China                               8,227,103
7 Brazil                               2,252,664
8 Russian Federation      2,014,775
10 India                              1,841,710
14 Mexico                           1,178,126
15 Korea, Rep.*                 1,129,598
16 Indonesia                      878,043
17 Turkey                            789,257
19 Saudi Arabia                 711,050
22 Iran, Islamic Rep.       514,060
26 Argentina                      475,502
28 South Africa                 384,313
29 Venezuela, RB              381,286
30 Colombia                      369,606

Source: World Bank

*It may be argued that South Korea shouldn’t be included since it has emerged.

The complete list is here:-

Click to access GDP.pdf


In the table above, the “Fragile Five” are all represented – although only two of the “Vulnerable Five” – with Thailand (31) just outside. Given their prominence however I want to examine the prospects for the largest EM economies – the BRICs:-

• China is a year into its economic rebalancing away from production and towards domestic consumption. This is a slow process; some commentators anticipate it may take as much as a decade to work through. Whilst GDP growth remains robust – IMF forecast real GDP of 7% plus out to 2018 – it is well below the nearly double digit growth of the last decade. As the world’s second largest economy China will set a benchmark for the rest of the developing world. Official statistical data from the PRC is notoriously unreliable so a true picture of the success or failure of economic reform may be difficult to discern. The level of debt, especially in the public sector, and the demographic effects of the “one child” policies of the Mao era, are likely to subdue economic growth for a considerable time.

The following article from Macrobusiness.com.au looks at Chinese Iron Ore port stocks: –


This indicates a continued slowing of the Chinese economy. Whilst Iron Ore port inventories are a rather narrow indicator of expected demand the recent decline in Rebar prices shows that demand from the construction industry remains muted.

• Brazil has been battling high inflation – 5.59% January 2014, down from 6.7% last summer but still above the central bank target of 4.5%. Growth has been slowing since the 2010 rebound and commodity prices have remained under pressure. An election in September 2014 and the opportunity for public protests around the FIFA World Cup add to the uncertainty.

• India has seen its currency under pressure for some time. Ranjan, the new governor of the Reserve Bank of India, has already raised interest rates three times, to 8%, since his election in September 2013. This only takes rates back to their 2012 level. Meanwhile industrial production is lacklustre and the bursting of the housing bubble continues to act as a drag on the economy. Inflation has been running in double digits for the past couple of years and only dropped to 9.13% in January.

• Russia has slightly less inflation concern (6.1% in January) and central bank rates have been held at 5.5% since September 2013. Commodity prices have remained a drag on growth (1.2% in Q3 2013). The current account surplus continues to diminish despite the relative stability of the oil price. Another issue for Russia is their standing on Transparency International’s Corruption Perceptions Index. Russia ranks 127, the lowest of the BRIC countries.

Full 2013 Transparency International CPI results are here:-


EM institutions must remain calm

Perhaps a greater risk for EM countries may be policy mistakes from there own institutions, as this article from the Peterson Institute – Emerging Market Victimhood Narrative – January 31st – suggests: –


From Istanbul to Brasilia to Mumbai comes a crescendo of complaints about dollar imperialism. Heads of state and central bank governors allege that the policies of central banks in industrial countries, especially the US Federal Reserve, pursued in self-interest, are wreaking havoc in emerging-market economies. This allegation is mostly unfair. Emerging markets aren’t hapless and undeserved victims; for the most part they are simply reaping what they sowed.

Interest rate increases by EM central banks to combat higher inflation due to currency depreciation poses a significant “contagion” risk. They should take note of the actions of the BoE, who missed its inflation target every month since November 2009. Now inflation is back to target (December 2013) and the UK economy is predicted to be the strongest in Europe this year, see last weeks post: –


For emerging market officials to blame the Federal Reserve might be populist but it will antagonise international relations. Emerging market central banks and their governments need to concentrate on those internal factors they can influence. International capital outflows can, to some extent, be reversed by raising interest rates precipitously but at what cost to the domestic economy?

Cross-border Capital flows and the “Carry Trade”

Since the Tech Bubble collapse of 2001, and subsequent slashing of interest rates during the mid-2000’s, a significant amount of developed country investment has flowed towards emerging markets. A large reversal occurred in 2009 but since then developed country central banks have cut interest rates aggressively encouraging renewed enthusiasm for EMs. After a steady period in 2012 credit inflows dried up as US bond yields began to rise. Since the second half of 2013 the overall trend has begun to reverse. The fascinating chart below from the World Bank illustrates the critical impact of credit inflows and outflows over the last 22 years: –

EM Private Capital Inflows - source World Bank

Source: World Bank

The recent outflows from emerging markets have benefitted capital account surplus countries; especially the UK – it is a factor underpinning the appreciation of GBP.

These “repatriations”, are likely to continue despite emerging market central banks increasing interest rates to defend their currencies. It is still quite early in the repatriation cycle and expectations are currently dominated by the prospect of further Fed tapering.

EM short term interest rates are rising but as the chart below illustrates 10 yr bond yields have not risen to extreme levels at this stage. The comments are courtesy of Mauldin Economics:-

EM Bond yields - source Mauldin Economics and Bloomberg

Source: Bloomberg and Mauldin Economics

Whilst yields have risen, the situation doesn’t look too dire, especially when compared to EM currencies; chart below again courtesy of Mauldin Economics: –

EM Currencies - source Mauldin Economics and Bloomberg

Source: Bloomberg and Mauldin Economics

The next chart, once more care of Mauldin Economics, shows the relatively stable, although high, inflation rates in some of the larger emerging markets. Several EM central banks have raised interest rates this year and I expect to see investors return to higher yielding bond markets as developed country bond yields fall – a kind of “self-righting” mechanism will see a return of capital inflows. This may take a few months to materialise and, should EM central banks panic, a full-blown crisis could ensue in the meantime. This month the sentiment is fragile, as exemplified last week by both the Russian and Brazilian governments’ cancelling their bond auctions. The point made by Maudlin is the crux of the issue: as developed market rates rise the attraction of the carry trade diminishes. I simply don’t expect developed market bond yields to rise dramatically when disinflationary forces are blowing from the depreciating EM’s.

EM Inflation - source Mauldin Economics and Bloomberg

Source: Bloomberg and Mauldin Economics

In some ways the marginal capital flows which affect currencies, bonds and stocks, are all a form of the classic “Carry Trade”. So what is different about the carry trade since 2008?

As developed world central banks cut interest rates towards the zero bound, so the carry trade, which had traditionally relied upon the JPY (and to a lesser extent the CHF) for funding, became attractive to fund in USD, EUR and even GBP. In the past, interest rate differentials between the major markets had been significant – and therefore attractive to the carry trader. In the new, post 2008 environment, the carry trade destination became more concentrated in less liquid markets such as peripheral European bonds, higher yielding mortgage and corporate bonds and, of course, emerging markets.

This article from Prospect Magazine – Are Emerging Markets a storm in a teacup, or a storm that’s brewing? – 6th February 2014 – picks up on a World Bank report: –

A recent study by the World Bank (Global Economic Prospects, January 2014) estimated that US interest rates, QE and other external factors accounted for 60% of the increase in capital flows to emerging countries between 2009-13, with domestic factors accounting for the remainder.

They go on to point out: –
So next time someone says emerging market currencies are a storm in a tea cup, you can remind them of two things. First, you can point out that slower growth, flawed development models, excessive reliance on credit and foreign capital inflows, and weak institutions constitute a rather different cocktail. Secondly, you can emphasise that raising interest rates to defend your currency doesn’t always work. It might just exacerbate the underlying problem of weak growth, low returns to investment, and political tension, and so spur another bout of capital flight, and so on.

At some point, a buying opportunity for the brave and fleet of foot in emerging markets is as certain as night follows day. But the emerging market growth crisis is still in Act 1 of a rather long play.


Another look at the currency and bond charts above suggests that whilst the currencies are leading the way, bonds are still broadly within their recent ranges. Many commentators anticipate higher EM bond yields in the wake of currency weakness, this remains a risk near-term. By contrast, EM equities, as measured by the MSCI EM Index, look range-bound. They failed to follow the major markets higher last year. Looking ahead, trade surplus EM countries will benefit from a weaker currency as it makes their export sector more competitive: –

MSCI Emerging Market ETF - 5 yr - source yahoo finance

Source: Yahoo Finance

Back in November 2013 Anders Aslund wrote, what may turn out to be, a prescient article for the Peterson Institute – Why Growth in Emerging Economies Is Likely to Fall, here are some highlights: –

The high growth rate of the emerging economies has become widely accepted as the new normal.
A new conventional wisdom has arisen, that economic convergence between the developed and the
emerging economies is all but inevitable and that China will soon overtake the United States economically and rule the world. Books such as Eclipse: Living in the Shadow of China’s Economic Dominance (Subramanian 2011) and When China Rules the World (Martin 2012) have become staples. However, the two preceding decades, 1981–99, off er a sharp contrast. Emerging economies grew only at an average of 3.6 percent a year during those decades, while the US economy grew at 3.4 percent a year. Considering that the initial US economic level was so much higher, no economic convergence occurred between the United States and the emerging economies during those two decades.

… The hypothesis of this paper is that the emerging market growth from 2000 to 2012 was atypically high and we might be back in a situation that is more reminiscent of the early 1980s. The growth of the last 12 years was neither sustainable nor likely to last. Several cycles that are much longer than the business cycle exist. One is the credit cycle, which Claudio Borio (2012) assesses at 15 to 20 years.

Another is the commodity cycle, which last peaked in 1980 and might last 30 to 40 years (Jacks 2013, Hendrix and Noland forthcoming). A third is the investment or Simon Kuznets cycle, which appears related to both the credit and commodity cycles (Kuznets 1958). A fourth cycle is the reform cycle, which might also coincide with the Kondratieff cycle (Rostow 1978).

The purpose of this paper is by no means to prove the existence of these cycles and even less to
discuss their length. My argument is much more limited: A large number of emerging economies seem to be close to a turning point in all these four cycles. The credit, commodity, and investment cycles have peaked out, while reforms on the contrary have tended to occur during crises and need to be restarted. It usually takes a decade or two to embark on, design, and implement new reforms. I offer seven arguments why high emerging-economy growth is over:
1. One of the biggest credit booms of all time has peaked out. Extremely low interest rates cannot
continue forever. A normalization is inevitable. Many emerging economies are financially vulnerable with large fiscal deficits, public debts, current account deficits, and somewhat high inflation.
2. A great commodity boom has peaked out, as high prices and low growth depress demand, while the high prices have stimulated a great supply shock.
3. The investment or Simon Kuznets cycle has peaked out, as the very high Chinese investment ratio is bound to fall and real interest rates to rise.
4. Because of many years of high economic growth, the catch-up potential of emerging economies has been reduced and growth rates are set to fall ceteris paribus.
5. Many emerging economies carried out impressive reforms from 1980 to 2000, but much fewer
reforms have taken place from 2000 to 2012. T e remaining governance potential for growth has
been reduced. Characteristically, reforms evolve in cycles that are usually initiated by a serious crisis, and after 12 good years complacency has set in in the emerging economies.
6. Worse, the governments of many emerging economies are drawing the wrong conclusion from
developments during the Great Recession. Many think that state capitalism and industrial policy have proven superior to free markets and private enterprise. Therefore, they feel no need to improve their economic policies but are inclined to aggravate them further.
7. Finally, the emerging economies have benefited greatly from the ever more open markets of the
developed countries, while not fully reciprocating. The West is likely to proceed with selective,
regional trade agreements rather than with general liberalization.

Here is the full article: –

Click to access wp13-10.pdf

Countering this well argued case for an EM slowdown is a fascinating paper from the BIS – Asia’s decoupling: fact, forecast or fiction? December 2013, here’s the abstract:-

Standard measures of real economic co-movement between Asia-Pacific economies and those elsewhere had been observed to follow a downward trend, leading some commentators to suggest that the region was decoupling. However, this process reversed in response to the International Financial Crisis, and co-movement increased to historically high levels for some economies. We examine co-movement patterns and show that these are very sensitive to changes in macroeconomic volatility over time. Controlling for this, however, co-movement is closely linked to underlying trade and financial integration. If international links continue to strengthen in future, co-movement will strengthen in tandem. Decoupling is more a fiction than a fact or a forecast.

Click to access work438.pdf

Developed markets and globalisation
If the world economy is becoming more coupled due to globalisation, then the monetary conditions of the major economies is critical to understanding how the nascent emerging market crisis might play out.

As a broad generalisation, emerging markets rely on Trade Exports and International Capital Investment, so the robustness of their trading and finance partners is a critical but often overlooked aspect of any analysis. I am indebted to Pi Economics for the chart below which tracks broad money growth in US, EU, UK and Japan.

Weighted Average Broad Money Growth - US EU Japan UK - source Pi Economics

Source: Pi Economics

Given that broad money growth of 4 – 5% is consistent with inflation of around 2% – a statement with which many would disagree since it ignores velocity, liquidity preference and a number of other factors – I would suggest that, as long as the Federal Reserve, ECB, BoE, BoJ etc. maintain inflation targets, further accommodative policies are likely to prevail.

For more reading on the link between broad money growth and inflation the ECB – Long Run Evidence on Money Growth and Inflation – WP 1027 – March 2009 may be informative, there’s plenty more from other central banks too.

Click to access ecbwp1027.pdf

With falling money supply growth disinflation is an increased risk. George Selgin – Less than zero –is an excellent introduction to the heterodox idea that falling prices are a good thing. This remains at odds with the inflation targeting mandates of the major central banks. Here is the IEA link:-

Click to access upldbook98pdf.pdf

Many EM countries already have some form of price, capital or currency controls in place. As international inbound capital flows have slackened or reversed many of these controls have been tightened. As those countries which can, weaken their currencies, their export competitiveness will improve. For the developed countries import prices should decline. This will temper domestic inflation, making higher interest rates unnecessary. Any domestic slowdown in economic activity in developed countries will then prompt an increase in QE.

Since the beginning of 2014 US, UK and German bond markets have rallied. Traditionally, lower bond yields, except during times of crises, are positively correlated to higher equity prices. With developed markets exhibiting anaemic growth, a reasonable proportion of this additional liquidity is bound to seek out higher yielding bonds and growth stocks. This will lead to renewed capital flows into EM equities.

Commodity prices remain subdued, see my post from last year: –


Many of the largest emerging economies are still slowing. More robust growth in the UK and USA looks like the exception rather than the rule for the developed world and money supply growth in the major economies is disappointingly weak. None of this suggests that the main catalyst of asset price appreciation (QE) will disappear in the next five years. If 60% of the capital flows into emerging markets are the result of QE, and the Federal Reserve are still buying $65bln per month, whilst the BoJ are attempting a similar degree of monetary accommodation, I can’t be bearish on EM equities.
It has been argued that the major central banks are mandated to focus on their domestic economies.

Commentators point to the Latin American crisis of the 1980’s or the Asian crisis of the late 1990’s as examples of how the rest of the world will be left to fend for themselves, however, I believe the impact of globalisation is under estimated. When the effects of globalisation are combined with benign inflationary forces in the developed world, together with central bank inflation targets, disinflation will lead to more QE. This will lead to further asset price inflation. We will finally reach a denouement where the mal-investments associated with these ridiculous policies are laid bare, but not until the credibility of central banks has been undermined.

We may yet have a full-blown emerging market crisis but I think it is less likely due to the increased interconnectedness of the world’s economies. If it does happen it will stem from a loss of confidence in EM institutions. The credit inflows pre-2008 have not returned. Regulatory capital increases have undermined the lending capability of banks around the world. There has been less “hot money” flowing to EM markets since the Great Recession and therefore I believe EM markets will keep their nerve.

Whilst their arguments are somewhat different from my own, the Economist – Don’t Panic – 1st February 2014, ends with a salutary warning and a longer-term expectation: –

If enough investors get nervous, money will flood out, currencies will fall and a gradual tightening could become a sudden rout. But there is no reason for American interest rates to rise fast, and no reason why emerging economies cannot adapt to a world in which rates gradually climb.


A major emerging market crisis is still a real risk, however, I believe the disinflationary effect of their currency depreciations, on the major developed economies will be pronounced. The developed world central banks will not raise interest rates in this environment. This will provide significant liquidity support to emerging markets – especially to equities and those bond markets where the government debt to GDP ratio is not too high, nor the current account balance in substantial deficit. As always, each emerging market should be analysed on its own merits – some deserve the treatment they are receiving at the hands of “Mr Market” others may be damaged by contagion. In general, however, I don’t expect a rout of the magnitude of 1997 this time around. Emerging market equities are a “hold”. They may break lower, in which case reduce, but don’t exit the market just yet, another round of developed world QE may appear, like a knight in shining armour, sooner than you think.

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