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Macro View: Emerging markets are facing dire pressures

Threats that an emerging market crisis could lead to a global recession have intensified. Central bankers are uncertain on how to react

THE global economy is now in treacherous territory. Threats that an emerging market crisis could lead to a global recession have intensified. Most stock markets dropped sharply in August, and central bankers are uncertain on how to react.

Concerns over slowing Chinese growth, and worries over the consequences of the US Federal Reserve’s plans to start raising interest rates soon, have been the immediate triggers of the recent turmoil. But it is clear that the malaise goes deeper. At the height of their plunge, US & European stock markets recorded falls well in excess of 10%. Even after share prices staged a partial recovery, they remain highly volatile and are susceptible to renewed downward lurches.

Adverse pressures are particularly severe in the emerging markets, which suffered capital outflows and saw sharp falls in their currencies and stock markets. With the exception of India and Mexico, which have so far been relatively resilient in the face of the turmoil, most emerging markets are facing mounting strains.

The impression of incompetence

Lower Chinese growth, which was widely expected for some time, is a necessary result of the official economic strategy aimed at restructuring China’s economy towards greater emphasis on consumer spending, while reducing reliance on investment and exports. This refocusing of the economy is correct and necessary. But the authorities have underestimated the political and economic obstacles they will face.

Chinese domestic debt levels have expanded too rapidly in recent years. Recent sharp falls in shares and downward pressure on the yuan are predictable reactions to major changes in the economy and, though uncomfortable, are not alarming. However, the reaction of the Chinese authorities, with clumsy efforts to support share prices, appeared panicky and give the impression of incompetence. Persistent suspicions that China’s official statistics are being manipulated by political pressures, and attempts to blame financial analysts for the recent turmoil, will only erode credibility further.

The Chinese economy has the strength to reform without a hard landing, and the authorities are now regaining control. But they will face serious challenges and they have to adopt a more open approach to avoid renewed turmoil. The slowdown in China’s growth is unavoidable, and the world will accept modest market-driven falls in the yuan. But attempts to engineer falls in the currency risk unleashing damaging currency and trade wars.

Sharp declines in Chinese imports are one of the main drivers of the persistent falls in world energy and commodity prices seen in recent years. The countries most severely afflicted include major players such as Brazil, Russia, Turkey, South Africa, and Malaysia. Following the 2008-09 financial crisis the emerging markets have been the main drivers of global growth, while the developed economies were forced to retrench, while they struggled to repair damaged banking sectors and cut back ballooning budget deficits.

A meaningless platitude

Recent events have changed this pattern. Although rich commodity exporters such as Australia and Canada have been under pressure, most developed countries have benefited from sharp falls in energy and commodity prices, which boosted real incomes and made possible rises in consumer spending. Growth in the G-7 is still disappointingly weak and they have not yet returned to their pre-crisis trends; but their banks are now healthier and their economies are slowly improving. In contrast, many emerging markets are facing dire pressures.

The famous BRIC acronym, coined to signify the rising status of the emerging markets, is now a meaningless platitude. Two BRIC economies, Brazil and Russia, will almost certainly record outright GDP declines in 2015, and both have been relegated to junk status in their respective sovereign credit ratings. Most emerging markets are likely to register weaker growth in the next few years and many will remain vulnerable to an unpleasant combination of credit rating downgrades, renewed capital outflows, and further pressures against their currencies. Even India and Mexico, though relatively less afflicted, may not remain immune if the situation worsens.

It is still premature to talk about a major crisis and an unavoidable global recession. Big sovereign defaults can still be avoided. But it would be a serious mistake to underestimate the warning signs. In many emerging markets current account deficits are ballooning and internal political pressures are worsening. The developed economies led by the US cannot ignore the wider effects of their domestic actions.

US GDP grew at an annualised rate of 3.7% in the second quarter of 2015, well above initial estimate and much faster than the 0.6% annualised rise in the first quarter. While the US recovery remains pedestrian when compared with previous cycles, the second quarter acceleration provides ammunition to those supporting early rises in official interest rates. However, the labour market data was unclear. The US economy created only a disappointing 173,000 new jobs in August 2015, about 50,000 less than expected. But the job figures for the previous two months were revised up markedly, and the US unemployment rate fell to a 7-year low of 5.1%.

Harmful effects

Uncertainties over the precise timing are less important than the growing likelihood that US official rates will start rising soon. The main challenge will be to deal with the consequences. With our full-year GDP growth forecasts upgraded to 2.5% for 2015 and 2.6% for 2016, the adverse effects of higher rates on the US domestic economy will be manageable, even if the financial markets suffer renewed turmoil. But the potential harmful effects on the emerging markets could be more serious. Much depends on the Fed’s ability to reassure markets that future rate rises will be modest and gradual. But there can be little doubt that global risks will increase as a result of the Fed’s actions.

Eurozone GDP growth for the second quarter of 2015 has been revised up slightly and we have upgraded slightly our 2015 GDP growth forecast to 1.5 per cent. But the European Central Bank (ECB) remains gloomy about growth prospects. In contrast to the US, where tightening is getting nearer, president Mario Draghi made it clear that he is ready to ease policy further if economic conditions show renewed signs of weakness.

In spite of the modest improvement this year, the eurozone economy remains weak, inflation at 0.2% is well below the target, and the current calm surrounding Greece could prove deceptive and temporary. The ECB will not consider any increase in official interest rates until well into 2017. Indeed, it will not be surprising if the ECB’s current quantitative easing programme is increased and extended beyond September 2016. In the UK, growth forecasts for 2016 have been upgraded. But the recovery is still fragile. Recent UK trade and manufacturing figures have been unexpectedly weak. There are growing signs that the first increase in UK official rates will only occur in the second quarter of 2016.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist

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