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Connecting the Dots on Emerging Market Risk

Jamus Lim's picture

With developed markets in a period of extended slow growth---and in some cases imploding---it is useful to consider emerging medium-term risks for emerging markets (pardon the pun). With global economies still experiencing a fragile recovery---especially in the private sector---small shocks carry the potential to be amplified by jittery financial markets, leading to a fresh crisis. We are already seeing a small spillover begin to present itself in Eastern Europe. To prevent derailment, therefore, the impetus rests on policymakers to remain alert to the possibility of such shocks. In this post, we attempt to connect some dots as we consider what the data are telling us about medium-term risks in the development world.

Source: World Bank staff calculations, from Bloomberg (TED spread) and Datastream (VIX and other spreads).

The most immediate downside risk emanates the effects that a slowdown in developed economies---with a small but nontrivial possibility of a double-dip, especially in both Western Europe---could be detrimental for export-dependent developing countries. The implications of contractions in import demand from Europe depends, of course, on the exposure that developing economies have to these economies (see figure). In this regard, ECA exposure is most vulnerable to a slowdown in the EU-25 (as one would expect from a standard gravity-type model), although the MNA region also has nontrivial trade exposure to Europe. Indeed, if exposure is limited to the EuroPeriphery, the MNA region is potentially at greater risk of Europe-induced slowdown (the caveat here is that many MNA exports to the EuroPeriphery typically take the form of energy exports, which are likely to be more import-inelastic than other types of exports).

Source: World Bank staff calculations, from UN COMTRADE database.

Notes: EuroPeriphery refer to Portugal, Ireland, Italy, Greece, and Spain; the EU-25 are the 27 current member states of the European Union excluding Romania and Bulgaria, which joined in 2007.

Such a slowdown could mean more than simply a reduction in export demand and an associated reduction in growth. As Michael Pettis has pointed out, thinking about the global economy was a closed system, the arithmetic of current account rebalancing requires that, should Europe contract and the developing world decline to allow greater exchange rate flexibility, major developed markets such as the U.S. must necessarily bear brunt of adjustment, which can raise protectionist sentiment. A flurry of competitive protectionism could then easily lead to another collapse in global trade and set the stage for recessionary pressures. Such policy-induced second-order risks are specially relevant given the rise in trade barriers since the onset of the financial crisis (G20 declarations notwithstanding).

A second risk is the possibility that inflation may get ahead of many developing countries. In stark contrast to developed markets---many of which are currently experiencing very low (PDF) levels of inflation or even skirting outright deflation---developing markets are either currently facing rising inflation. This is best exemplified by the vigorous (and some would call overheated) economies of China and India (see top figure). The so-called China bubble, in particular, is well documented. Analysts such as Andy Xie have griped about unsustainable bubbles in asset markets across China, especially in the real estate market; while such proclamations may be risk-averse hyperbole, it is undeniable that housing prices have risen steadily for a year and a half now (see bottom figure). Moreover, real estate inflation is likely to be even more rapid when focusing on data from the coastal regions alone.

Source: World Bank staff calculations, from Datastream.

Notes: Indian (Chinese) CPI inflation on left (right) axis. Series are not adjusted for seasonality.

Source: World Bank staff calculations, from Datastream.

Notes: Series are not adjusted for seasonality.

Even for countries not currently under inflation pressures, emerging economies may still face future inflation as upstream pressures, as measured by the PPI, work their way into consumer prices. This is the case for Brazil, Russia, and Turkey, all of which are seeing increasing trends in their recent PPI numbers (see top figure). Another foreboding sign is that in many of these economies, domestic credit growth has remained stagnant or fallen in the face of such pressures (with perhaps the exception of China), which suggests that the relaxed monetary policy stance has not translated into increased credit availability (see bottom figure). This may mean that inflation in these countries is not so much as monetary as an expectational phenomenon---and once expectations are entrenched, they become much harder to reverse.

Source: World Bank staff calculations, from Datastream.

Notes: Russian and Turkish (Brazilian) PPI inflation on left (right) axis. Series are not adjusted for seasonality.

Source: World Bank staff calculations, from IMF IFS.

Notes: Year-on-year growth in domestic credit (series 32..ZF).

Inflationary pressures can easily be exacerbated by policy choices such as a steadfast reluctance to allow exchange rates to operate freely while entertaining surging capital inflows. While such inflows have moderated significantly since peaks in 2007 (see figure), whether emerging markets are able to successfully manage and absorb such flows remains an open question. While some developing economies have tinkered with the possibility of imposing limited capital inflows, the balance between limiting the inflationary impact of inflows and the beneficiary effects of such inflows for financing development remains a challenging rightrope.

Source: World Bank staff calculations, from WB GDF.

Notes: Net inflows aggregates official and private inflows. Bars (lines) are net inflows measured in USD billions (as % GDP).

Finally, equity markets around the developing world appear to be underperforming (see figure). While EM equities have certainly staged a recovery in accord with developed country stock markets, the recent correction may be a warning sign of the possibility that growth in the emerging market economies may also temper as the developed world slows down. The Shanghai stock exchange, in particular, is currently less than half the levels attained at the pre-crisis peak.

Source: World Bank staff calculations, from Datastream.

Notes: The MSCI Emerging Markets (EM) and EM Europe, Middle East and Africa (EMEA) comprise 21 and 8 emerging market stock indexes, respectively. The MSCI Europe, Australasia and Far East (EAFE) index comprises 22 developed market stock indexes.

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