David Bartlett is director of global and strategic projects at Kogod School of Business, American University (Washington,D.C.) and economic advisor at RSM
By most measures, emerging markets have outperformed developed economies since the Great Recession. Between 2010 and 2014, emerging/developing economies posted averaged annual real GDP growth of 5.8% versus 1.8% in the advanced industrialised countries. While foreign trade and investment slowed in many developed economies, emerging markets registered expanding shares of global trade and foreign direct investment in the post-recession period. Against a series of financial crises in developed countries, emerging markets enjoyed strong financial indicators, reflected in favourable sovereign debt ratings.
However, in 2015 emerging markets have experienced powerful economic headwinds that raise doubts about their capacity to drive global recovery and heighten fears of a ‘New Mediocre’ of weak growth in coming years.
Slowing GDP Growth
On 9 July, the International Monetary Fund (IMF) released an updated World Economic Outlook that forecasts world GDP growth of 3.3% in 2015, rising to 3.8 percent in 2016. The IMF projects 2.1% growth in developed economies in 2015, increasing to 2.4% in 2016. For emerging/developing economies, the IMF predicts growth rates of 4.2% in 2015 and 4.7% in 2016. While these projections indicate a continued growth premium of emerging over developing economies, they also signal a deceleration of emerging market GDP growth from 2010-14 rates.
The emerging market slowdown is most apparent in China, which is forecast to slow from 7.4% GDP growth in 2014 to 6.8% in 2015 and 6.3% in 2016. Some analysts believe even these figures overstate actual growth rates in China. Both Brazil and the Russian Federation face economic contractions in 2015 (-1.5% and -3.4% respectively). The projected GDP growth rate of South Africa (2.0 %) falls well below levels in other Sub-Saharan countries. At 7.5%, India has emerged as the economic growth champion of the BRICS group.
The economic slowdown in the emerging markets stems from several factors:
- Flagging export demand in the European Union, the foremost trading partner of China and other emerging markets.
- Weak prices of global commodities, which represent a major share of the exports of resource-centric emerging markets like Brazil and Russia.
- Declining external capital flows, reflecting the foreign investor community’s perception of the increased risk of emerging market investments.
However economic growth remains strong in a number of emerging markets, illustrating the high variability of GDP growth rates worldwide. But the economic deceleration in the large BRICS countries (with the notable exception of India) signals a recalibration of earlier expectations of emerging markets serving as engines of world economic growth.
Rising Emerging Market Debt
The aftermath of the 2008 and 2009 crisis demonstrated the growing international financial power of emerging markets, which drew on their expanding stocks of foreign exchange to serve as global liquidity buffers. But emerging markets also incurred heavy amounts of external debt during the post-recession period.
According to the McKinsey Global Institute, developing/emerging economies accounted for nearly half of the $49trn in new debt issued globally between 2007 and 2014 (‘Debt and Not Much Leveraging’, February 2015). During this period, China’s total debt reached $28trn, boosting that country’s debt-GDP ratio from 158% to 282%. Other emerging markets such as Hungary, Malaysia, Thailand, and Slovakia indulged in a borrowing spree, capitalising on the easy credit environment of the early post-recession period.
A large proportion of these emerging market debts are dollar denominated, reflecting the allure of historically low interest rates under the U.S. Federal Reserve’s quantitative easing programme. The termination of that programme and anticipated increase in American interest rates – coupled with the recent appreciation of the U.S. dollar – place many emerging market borrowers under mounting financial pressure as their USD loans come due.
Equally significant, a major share of new emerging market debts stems from corporate bonds. Emerging market corporate bonds outstanding have increased seven-fold over the past decade, the fastest growing fixed income asset class in the world.
Approximately 30% of emerging market corporate bonds issued in 2014 and 2015 are hard currency denominated, of which U.S. dollar issues represent more than 80%. USD-denominated bonds issued by emerging market-based companies now total $1.5trn, exceeding the size of the high-yield corporate bond market in the United States. The surge in corporate bond issues by emerging markets is led by Brazil, China, Russia, Mexico, and the United Arab Emirates.
The ascent of emerging market corporate bonds as an international financial asset class is a positive development, signalling the growing integration of emerging market-based companies in the global economy. It also enlarges the range of external financing available to developing and emerging economies, which will require trillions of dollars infrastructural and human capital investment in coming years. But this development also underscores the increasing vulnerability of the emerging markets to turbulence in the global financial system, notably changes in exchange rates and interest rates that raise the cost of external debt service.
In early August 2015, the People’s Bank of China instigated a devaluation of the Renminbi (RMB), a measure aimed at: correcting the real effective appreciation of the dollar-pegged RMB, accelerating China’s migration towards market-determined exchange rates to prepare for the RMB’s inclusion in the IMF’s Special Drawing Rights (SDR) basket, and stimulating Chinese exports amid decelerating GDP growth.
While the size of China’s currency devaluation (3%) was small, it roiled global stock markets and raised the spectre of a spate of competitive devaluations by other emerging markets. China’s recent move also demonstrated the global ramifications of the realignment of foreign exchange rates. Since 2013, the U.S. dollar has appreciated 30% against emerging market currencies. The forthcoming increase in U.S. interest rates (along with America’s continued GDP growth advantage over the European Union and Japan) presages further dollar appreciation in 2015 and 2016.
The weakening of emerging market currencies against the U.S. dollar confers major benefits to emerging market-based exporters, which enjoy improved price competitiveness and increased earnings when they convert their USD revenues into the local currency.
But currency devaluation also threatens the debt servicing capacity of emerging market companies that undertook large USD debts in the early post-recession years.
According to the Institute of International Finance, $375bn of USD non-financial corporate debt issued to emerging markets will mature between 2016 and 2018, with another $360bn maturing in the following three years (‘Corporate Debt in Emerging Markets: What Are the Risks?’). Nearly 20% of these debts are held by emerging market companies that are fully exposed to exchange rate shifts. Emerging market-based oil, gas, and mineral companies that would ordinarily enjoy natural hedges against foreign exchange risk now face declining USD revenues as global commodity prices plummet.
The structural factors underpinning the global rise of emerging markets remain intact: their steadily rising shares of world GDP; their growing prominence in foreign trade, investment, finance, and technology; their expanding middle classes with increased purchasing power; and their impressive endowments of human capital.
At the same time, the deepening integration of emerging markets in the world economy also heightens their vulnerability to exchange rate shifts, commodity price fluctuations, and other disturbances. The recent turbulence on the Shanghai Stock Exchange (culminating in the ‘Black Monday’ sell-off of 24 August) dramatises the economic challenges facing emerging markets.