Which Emerging Economies Will Survive?
Source：Top Photo Group / Reuters
The post-QE era has commenced. The world's emerging markets that sparkled with opportunity yesterday are now facing economic distress. Which countries are most at risk? And is Taiwan in the clear?
Which Emerging Economies Will Survive?By Yi-Shan Chen
From CommonWealth Magazine (vol. 543 )
Before new Federal Reserve chair Janet Yellen presides over her first monetary policy meeting this week, speculation is rife as to whether she will go for a rate hike or rate cut. Market pundits are holding their breath as they try to determine the Fed chief's intentions, almost as if they are picking petals off a flower, alternately saying, "The rate will go up" and "The rate will go down."
Taiwan's central bank governor Perng Fai-nan – the only incumbent central bank boss worldwide who was already in office during the Asian financial crisis in the late 1990s – pinpoints spill-over effects from the aftermath of the rollback of quantitative easing in the United States as the leading cause of uncertainty regarding global economic growth prospects.
A week before the crucial Fed meeting, the Organization for Economic Cooperation and Development (OECD) made a rare appeal to Yellen, urging her to show consideration for the economic health of the emerging economies. After all, these account for 40 percent of the global economy.
Yellen's predecessor, Ben Bernanke, first mentioned a reduction of the scope of quantitative easing in a congressional hearing on May 22 last year. In the nine months since, the disquieting signals from the Fed have already caused four global stock market plunges.
More than US$20 billion in capital has been pulled out of emerging nation stock markets and bond funds. If we assume this to equal 10 million transactions, then the Taiwan stock exchange would continue to drop for 16 years as a result of such a massive capital drain. Seventy percent of fund investors in Taiwan who have invested more than NT$1 million are likely to see the value of their investments shrink.
Taiwanese investors in Southeast Asia are also beginning to feel the pinch from political and economic turmoil. In Thailand, for instance, "the Taiwanese investors who have been there already for a long time can't just leave, but even the Thai foreign minister acknowledges that many investors have transferred their investments to Indonesia," observes Namita Lin, a Bangkok-based correspondent for Taiwan's Central News Agency.
As a result of capital outflows and four months of political unrest, the Thai baht has depreciated 7.29 percent over the past nine months. Its stock market has nosedived 15.62 percent.
The Golden Age Is Over
Hardly any of the emerging economies, be they Brazil, India, Indonesia, South Africa or Turkey, have been spared from the onslaught.
In mid-March China, originally the only exception to the rule, also showed sign of distress, as exports shrank, the renminbi lost value, and stock markets plummeted. Presently, no one dares to say how the Chinese central bank will deal with the situation.
The Economist magazine described the mood among rich-world firms that have massively invested in emerging markets with the headline "Submerging hopes." Mobile network provider Vodafone, which has heavily invested in India and Turkey, has seen its profits erased by steep currency declines.
The once dazzling emerging economies have lost their luster. Yesterday, the sales pitches created by the financial wizards over the past decade still rang true; today they don't. Exactly what has changed?
If the first decade of the 21st century was the golden age of the emerging markets, does that mean that they have been dealt a death blow now?
Market Disruption No. 1: Capital Flight for 3 to 5 Years
The Fed began to use low interest rates to rescue the economy after the dot.com bubble burst at the beginning of the century. As a result, around the world investors pumped a record amount of money into the emerging markets.
But with the beginning of this year, quantitative easing will be tapered and eventually phased out. The Fed will return to its traditional monetary tool – raising interest rates. The longest and largest program for money creation in human history will make way for the siphoning off of liquidity on an unprecedented scale.
That is the first major disruption the emerging markets will face.
"In the coming three to five years, we won't see times of cheap capital again," one currency expert predicts bluntly.
In fact, the cost of capital has already skyrocketed in many emerging markets. Taking Indonesia as an example, the Indonesian central bank has raised the benchmark interest rate from 3 percent to 7.5 percent in the past nine months.
In India the central bank policy rate rose to 8 percent. In Turkey it stands at 12 percent, and in Argentina at a sky-high 28.8 percent. Perng has more than once warned that the risk of rising interest rates must not be overlooked.
He has reiterated over and over again that the global economy is presently not yet experiencing the effects of a withdrawal of quantitative easing, since the Fed is only stepping on the brakes of the money printing press. It is generally expected that the Fed will stop pumping out currency altogether at year-end. But real quantitative tightening is not likely to happen until after next year, when the Fed will likely begin to rein in money supply.
The big test will come for the emerging economies when interest rates begin to rise from the middle of next year.
Can you imagine the scope of this global liquidity withdrawal? As of the end of February this year, the Fed had pumped US$3.67 trillion into the market, roughly seven times the value of Taiwan's entire economy. When the Fed withdraws an equivalent amount of American dollars from the money market in the coming decade, not only will interest rates go up, but the US dollar will also appreciate.
A Stronger Dollar Means Trouble
"From an economic perspective, the emerging markets are bound to run into problems under a strong dollar regime," Dong Tao, managing director and chief economist for non-Japan Asia at Credit Suisse Group AG, once noted.
Three years after the US dollar began to appreciate in 1992, the Mexican peso crisis erupted. Five years later the Asian financial crisis hit, followed by the Russian financial crisis in 1998 and economic meltdowns in Argentina and Brazil in 2001/2002.
Over the past nine months a crisis in confidence has been building in several vulnerable economies.
The International Monetary Fund (IMF) uses two yardsticks to identify countries that are at high risk once the times of quantitative easing are over: external vulnerabilities caused by an excessively high trade deficit relative to overall economic activity and domestic vulnerabilities caused by real credit growth in excess of GDP growth. (Table 1)
If credit expands faster than the economy grows, an asset bubble is created. Once the bubble bursts a mountain of bad debt remains, which leads to greater domestic vulnerabilities. If a country suffers from a chronic trade deficit, its foreign reserves become depleted. If foreign investors pull out capital or if the country needs to pay back external debt, it might then not have enough US dollars to balance the outflow of foreign capital or service its debt.
IMF research shows that Brazil, Chile, India, Indonesia, South Africa and Turkey all face great external and domestic vulnerabilities. The current account of Ukraine, currently hit by an ongoing political crisis and Russia's military occupation of Crimea, also shows a trade deficit. This means the most pressing task vulnerable countries need to tackle is turning their trade deficits into surpluses.
Yet this might prove difficult, since the current commodity supercycle, which drove up prices for energy and raw materials worldwide over the past decade, benefitting commodity-exporting countries, has come to its end. The end of this supercycle will cause the second major disruption in the post-QE era.
Market Disruption No. 2: End of the Resource Supercycle
Liang Kuo-yuan, president of the Yuanta/Polaris Research Institute, points out that just a few years ago experts were busy trying to predict when the maximum rate of petroleum extraction would be reached. It was widely expected that prices for oil and other energies would remain high in the long term.
Since mining and the metal production and processing industries heavily rely on oil and other energies, the prices of such commodities also soared. As large stretches of agricultural land were used to plant energy crops for biofuels to substitute expensive petroleum, the prices for food crops went up as well.
The commodity supercycle was also fueled by rising demand from a rapidly expanding middle class, first of all, in China. Therefore, many experts believed that the world had entered a resource supercycle during the past decade that would keep commodity prices high for a long time to come. But Liang explains, "Technological innovations such as drilling for shale gas and China's economic restructuring have broken this cycle." After falling, commodity prices will stabilize in the medium term, Liang predicts. Countries that are overdependent on earning foreign currency through raw material exports will face tough times.
In late 2012, Edward L. Morse, global head of commodities research at Citigroup in New York and formerly with the US Energy Information Administration, was the first to warn, "It is now clear that the commodity super cycle is over."
Morse argued that China, whose economic growth rate hovered around 10 percent in the past, is restructuring its investment-driven growth model to make domestic consumption the major growth driver. Given that the Chinese economy, the largest buyer of raw materials, is slowing down, Morse predicted that demand for many raw materials such as copper, nickel, lead, petroleum and coal would plummet.
In its latest commodity markets outlook, the World Bank said in January that prices for precious metals, metals, agricultural products and fertilizer fell significantly in 2013 between 17 percent and 5 percent year-on-year. Primary commodity prices are expected to decline further in 2014-2015, with agricultural commodity prices slipping a further 2.5 percent and fertilizer prices almost 12 percent.
Huang Chao-jen, the former head of the Research Division of South East Asia at the Taiwan Institute of Economic Research, believes continued downward pressure on prices of raw materials will be a major challenge for emerging countries in Asia. "It depends on the how far China will go in its economic restructuring, environmental protection and rebuilding its steel and coal industries. When economic restructuring is over in three to five years, the economies of these countries will see another upswing," Huang predicts.
The fairytale boom of raw materials and capital flows into emerging markets during the first decade of the 21st century will come to a rude end in the second decade.
The withdrawal of quantitative easing will be like the last stroke of midnight, changing everything back to basics.
Key to Prosperity: Escaping the Middle-Income Trap
Huang believes it would not be fair to say emerging Asia did not make any progress since the 1997 Asian financial crisis.
During the past ten years, many emerging Asian countries went through transfers of governmental power, carried out structural reforms, advocated regional cooperation and developed rising civic awareness. They founded regional organizations and became more independent, more transparent and more cooperative, because they realized they could not remain dependent on the West.
The Southeast Asian nations have now all accumulated substantial foreign reserves, not by attracting hot money, but by doing genuine business and exporting minerals.
Figures reflect this change. Indonesia currently boasts a per capita annual income of US$3,557, which makes it a middle-income country, based on World Bank classifications.
Looking at the bigger picture, the key for continued prosperity in emerging Asia in the post-QE era is which countries will be able to escape from the middle-income trap and which nations can develop functioning institutions as emerging democracies.
Given that hot money is going to be a rare commodity, many experts predict that the coming era will take us back to the basics.
CommonWealth Magazine assessed the potential for prosperity among major emerging nations around the world, including those in Asia, based on five indicators: economic growth rate; ease of doing business; basic infrastructure ranking; anti-corruption index; and human capital, namely the ratio of young people with a higher education. (Table 2)
The results reveal that India and Indonesia, the hardest hit countries in the past nine months, showed extremely slow progress or even moved backward in all of these five real economy-related indicators.
India, for instance, ranks 134th for ease of doing business, down one spot from five years ago. Indonesia, for its part, ranks 56th for basic infrastructure, also a worse performance than five years ago.
Both countries are still listed among the most corrupt nations, having made very little progress since five years ago. On top of that, literacy rates and the percentage of the population that has attained higher education are low. The skill levels of the workforce are probably not good enough to support industrial transformation. Therefore, both countries have been listed as low potential countries, alongside the Philippines.
In contrast, the onslaught from a QE withdrawal on Malaysia is likely to be limited, because the country has advanced 17 spots in terms of ease of doing business, is neck-and-neck with China in basic infrastructure and has shown marked improvement in the anti-corruption index. Still, the percentage of people with higher education in the population is rather low. For the Southeast Asian nation, which boasts a per capita GDP of more than US$10,000, its under-skilled workforce remains the greatest vulnerability.
Within emerging Asia it is most difficult to judge Thailand solely on the basis of economic indicators. "From the outside you can't see at all the mechanisms for forging consensus through democratic procedures," says Wang Hung-jen, assistant professor at the Department of Political Science of National Cheng Kung University.
Wang points out that the criteria used by the West when judging whether Asian countries are democratic are whether elections have been held and whether there has been a change in the ruling party. But Thailand offers the best example of a government that has not been able to win the people's trust and forge consensus, despite a democratic process.
Political unrest erupted there in 2005. Since then intermittent mass movements have marred the country up to today. The country's troubles are reflected in the economic indicators. Thailand has slipped six spots in the past five years both in ease of doing business and basic infrastructure, and corruption is more severe than in India and the Philippines.
Key for Risk Avoidance: Political Efficiency
Turkish-born American economist Daron Acemoglu, author of Why Nations Fail: The Origins of Power, Prosperity, and Poverty, once warned in an interview with CommonWealth Magazine that both prosperity and democracy could regress.
After researching 1,000 years of world history, he concluded that the key for a nation's success is not its wealth in natural resources, but whether its system becomes more inclusive to allow more people to share the fruits of prosperity. Shallow democracies are very likely to be taken hostage by political and economic elites.
In other words, the factors that whetted the appetite of investors over the past decade, such as raw materials, demographic dividends and population figures, are not crucial at all. What counts are institutional and systemic factors such as government efficiency, absence of corruption, quality of human resources and the investment environment.
For the emerging nations, the knock-out competition of the post-QE era is on. Most likely, reality is going to get truly brutal.
Translated from the Chinese by Susanne Ganz