THE GLOBAL ECONOMIC ENVIRONMENT FOR EMERGING MARKETS

JEFFREY FRANKEL
HARPEL PROFESSOR OF CAPITAL FORMATION AND GROWTH

HARVARD UNIVERSITY

ANNUAL SYMPOSIUM ON CAPITAL MARKETS MEDELLIN, COLOMBIA, MAY 3, 2012

TWO - SPEED RECOVERY:

EMS BOUNCED BACK FROM THE 2008-09 GLOBAL RECESSION MORE STRONGLY THAN ADVANCED ECONOMIES

World Economic Outlook, IMF, April 2012

EM RECOVERY FROM THE GLOBAL RECESSION CONTINUES STRONGER THAN USUAL, BUT NOT SO FOR ADVANCED ECONOMIES.

SINCE LAST YEAR, THE IMF HAS REVISED 2012 GROWTH ESTIMATES DOWN SLIGHTLY, ESP. FOR EUROZONE.

World Economic Outlook, IMF, April 2012

Rate of growth of real GDP (%),

Projections for 2012 & 2013
World Economic Outlook, IMF, April 2012

Euro-recession is pulling down growth. The US is doing better.

Emerging Market growth is slowing too, but solidly >0.

FOUR BIG RISKS THREATEN THE GLOBAL OUTLOOK

Big means, not high probability per year,
but probability > 20% per year, with big consequences if it were to happen.

1) New crisis => more defaults on periphery, higher spreads even in northern Europe & possible break-up of -zone. 2) New partisan US budget stand-off.

3) Return of risk off; EMs hit?

4) Commodity price volatility E.g., world oil prices double again.

(1) THE CRISIS OF SOVEREIGN DEBT

IN THE EURO PERIPHERY WILL RETURN
The flash point right now is Spain. The trigger in a year could be Greece, again:

Greece cannot get back to a sustainable debt path by austerity, as has been clear for awhile. When it eliminates its primary budget deficit, no more incentive to keep servicing debt. => default. By then Euro banks may no longer have life-threatening exposure having passed debt to ECB, EFSF+ provisioned.

With default, Greek exit from euro begins to make sense.

Or Portugal or Italy. Regardless, contagion to others. This time it will probably hit France as well. Could contagion reach other high-debt countries?
UK? Japan? US?

DEBT/GDP IS ALMOST THE HIGHEST IN A CENTURY, SECOND ONLY TO WWII SPIKE

ACROSS ADVANCED COUNTRIES,

(2) US DEFICIT WOES WILL RETURN

The US has mismanaged its finances as badly as Europe.
The US doesnt have the excuse of 17 legislatures, just two deadlocked political parties.

It is a long-term problem:
i) Future deficits in entitlement spending
social security & Medicare.

ii) Current budget deficits since 1981

Steps in 1990s to restore surplus worked, but were reversed in 2001.

THE US NATIONAL DEBT AS A SHARE OF GDP

SOURCE: CBO, MARCH

ONE OBSTACLE, ABOVE ALL OTHERS

One of the two political parties has been hi-jacked by a minority who say fiscal balance is urgent, but also say it can be done entirely by cutting domestic spending:
They want to cut taxes & raise military spending at the same time as eliminating the deficit, which is mathematically impossible.

Prevents any sort of deal like 1990

which slowed spending growth & raised taxes during the 1990s.

THE GAME OF CHICKEN

In the 1955 movie Rebel Without a Cause, whoever jumps out of his car first supposedly loses the game.
James Dean does; but the other guy miscalculates and goes over the cliff.

THE DEBT-CEILING GAME OF CHICKEN In the summer of 2011, fiscal conservatives recklessly threatened government default, if their demands were not met.
The resulting political dysfunction led S&P to downgrade US bonds from AAA to AA.

A last-minute solution postponed the deadline to the end of 2012:

If no action is taken then, (i) all tax cuts expire, (ii) all discretionary spending is cut drastically, & (iii) the debt ceiling law is probably violated anyway. I.e., a return of the stand-off:
=> Danger of recession and default !

3) RETURN OF RISK OFF ENVIRONMENT?

Financial markets have swung back and forth between periods of risk-denying reach for yield & periods of risk-obsessed flight to safety.

Risk perceptions were far too low in 2003-07. Shot up in 2008-09; Down in 2010-11. Up again?

SOVEREIGN SPREADS DEPEND ON RISK PERCEPTIONS, AS REFLECTED IN THE VIX

(OPTION-IMPLIED VOLATILITY OF US STOCK MARKET)

Risk off Risk on

Risk on

Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011

ARE EMS VULNERABLE?

Historically, international financial shocks (a rise in risk-aversion and/or interest rates) hit Emerging Markets harder than anyone:
1982: International debt crisis (esp. Latin America)

1997: East Asia crisis (spreading to Russia, Brazil).

Worryingly, EMs seem subject to15-year cycle:

7 years of capital inflow drought; 7 year of capital inflow flood; Crisis hits in 15th year.

THE BIBLICAL CYCLE

Joseph prophesied 7 years of plenty, with abundant harvests from a full Nile -- followed by 7 lean years of drought & famine. The Pharaoh empowered his technocratic official (Joseph) to save grain in the 7 years of plenty,
building up sufficient stockpiles to save the Egyptian people from starvation during the bad years.
-- a valuable lesson for todays government officials in industrialized & developing countries alike.
17

BIBLICAL CYCLE, CONT.

For emerging markets, the first phase of 7 years of plentiful capital flows occurred in 1975-1981,
recycling petrodollars as loans to developing countries.
The international debt crisis that began in Mexico in 1982 was the catalyst for the 7 lean years,

known in Latin America as the lost decade.

The turnaround year, 1989, saw the first issue of Brady bonds, which helped write down the debt overhang

and put a line under the crisis.

18

BIBLICAL CYCLE, CONT.

The second cycle of 7 fat years was the period of record capital flows to emerging markets in 1990-96.
The 1997 sudden stop in East Asia was then followed by 7 years of capital drought.

The third cycle of inflows, often identified with carry trade and BRICs came in 2004-2011
and persisted even through the Global Financial Crisis.

If history repeats itself, it is now time for a 3rd sudden stop of capital flows to emerging markets!

19

ARE EMERGING MARKETS DUE FOR A CORRECTION, TRIGGERED BY A NEW WAVE OF RISK OFF BEHAVIOR?
Most worrisome: Turkey.
Turkey can probably not sustain the rapid economic growth and very high trade deficits of recent years. Vulnerable to world oil price.

China could land hard as its real-estate bubble deflates and the countrys banks are forced to work off bad loans.

High GDP growth rates in Latin America over the same period could reverse,
particularly if global commodity prices fall
Esp. if the cause is that the Chinese economy begins to falter.
20

BUT: A REMARKABLE ROLE-REVERSAL SUGGESTS EMERGING MARKETS ARE NO LONGER SO VULNERABLE: Debt/GDP of rich countries (> 80%) is now more than twice that of emerging markets;
and rising rapidly.

+ Even EM debt intolerance may be diminishing.

creditworthiness for given debt/GDP -- Reinhart & Rogoff

=>

Some EMs Economies are now more creditworthy than some Advanced Economies
as reflected in credit ratings or sovereign spreads.
21

Public finances since 2001 have become much stronger in EMs

BUT WEAKER IN ADVANCED ECONOMIES.

World Economic Outlook, IMF, April 2012

COUNTRY CREDITWORTHINESS IS NOW INTER-SHUFFLED

Advanced Countries (Formerly) Developing Countries

AAA Germany, UK AA+ US, France AA- Japan A+ ABBB+ Ireland, Italy, Spain BBB BBB- Iceland BB Portugal B CC Greece

Hong Kong, Singapore

China Chile, Korea Malaysia, Botswana South Africa, Thailand Brazil Colombia, India, Indonesia Costa Rica, Jordan, Philippines Burkina Faso
S&P ratings, Apr.26, 2012

EM SOVEREIGNS USED TO HAVE TO PAY HIGHER INTEREST RATES THAN US HIGH-YIELD CORPORATES (BB), BUT NOW PAY LESS.

ONE INDICATION OF IMPROVED EM CREDITWORTHINESS:

World Economic Outlook, IMF, April 2012

HISTORIC ROLE REVERSAL IN THE CYCLICALITY OF FISCAL POLICY IN INDUSTRIALIZED VS. DEVELOPING COUNTRIES
In the textbooks, benevolent governments are supposed use discretionary fiscal (& monetary) policy to dampen cyclical fluctuations.
expanding at times of excess supply, and contracting at times of excess demand.

But in practice,

Copyright Jeffrey Frankel,

PRO-CYCLICAL FISCAL POLICY

THESE 3 PAGES WERE IN L3 APP. IN 2010

In practice, policy has often been procyclical, i.e., destabilizing, in developing countries:

Governments would raise spending in booms; and then be forced to cut back in downturns.
Kaminsky, Reinhart & Vegh (2004), Talvi & Vgh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006), Ilzetski & Vegh (2008) and Medas & Zakharova (2009).

Especially Latin American commodity-producers.

Gavin & Perotti (1997), Caldern & Schmidt-Hebbel (2003), Perry (2003), and Villafuerte, Lopez-Murphy & Ossowski (2010).
Copyright 2007 Jeffrey Frankel, unless otherwise noted

Correlations between Gov.t Spending & GDP

1960-1999
Adapted from Kaminsky, Reinhart & Vegh, 2004,
When It Rains It Pours

Pro-cyclical spending

procyclical countercyclicall

Countercyclical spending

G always used to be pro-cyclical for most developing countries.

AN IMPORTANT DEVELOPMENT -IN THE LAST DECADE, SOME DEVELOPING COUNTRIES WERE ABLE TO BREAK THE HISTORIC PATTERN:

They took advantage of the 2003-08 boom

to run budget primary surpluses.
and build reserves.

By 2007, Latin America had reduced its debt

to 33% of GDP, as compared to 63 % in the United States.

And so had fiscal space to respond to the 2008-09 recession. I.e., some emerging market countries finally achieved countercyclical fiscal policies.

CORRELATIONS BETWEEN GOV.T SPENDING & GDP

2000-2009
procyclical countercyclical Frankel, Vegh & Vuletin (2011)

In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:

Negative correlation of G & GDP.

TO SUMMARIZE THE FISCAL ROLE REVERSAL,

Many important emerging markets have, so far this century, achieved: Lower debt levels than advanced economies; improved credit ratings; lower sovereign spreads; and less procyclical fiscal policies.

LESS VULNERABLE TO CRISES IN OTHER RESPECTS AS WELL:

More flexible exchange rates than before 1997. Higher fx reserve holdings
E.g. relative to short-term debt.

Less prone to current account deficits. Capital inflows less concentrated in $ bank debt
And local-currency debt. More FDI.

Exception: the one region that apparently didnt learn the lessons of the 1990s was Eastern Europe.

(4) COMMODITY PRICE VOLATILITY

Prices of oil, minerals & agricultural commodities have become increasingly volatile in recent years.
Especially sharp spikes in 2008 & 2011
With a crash in between.

Commodity price volatility likely to continue. Whether a commodity price rise is good or bad
depends on
(i) whether you are a buyer or seller (ii) the cause of the increase.

COMMODITY PRICES HAVE BEEN ESPECIALLY VOLATILE OVER THE LAST DECADE
Commodity prices: all commodities
Indices 180 160 140 120 100 80 60 40 20 0 60 61 63 64 66 67 69 71 72 74 75 77 79 80 82 83 85 86 88 90 91 93 94 96 98 99 01 02 04 05 07 09 10 in prices of 2010
A.Saiki, Dutch Nat.Bk.

Nominal prices
2010=100

Real prices In prices of 2000*

= nominal in 2000

*) Deflated by US consumer price index. Source: HWWA, Datastream.

COMMODITY PRICES SPIKED IN 2008, AND AGAIN IN SPRING 2011

Oil

World Economic Outlook, IMF, April 2012

WHAT DETERMINES COMMODITY PRICES?

Various idiosyncratic factors in each sector.
When wheat prices go up, it could be Australian drought, Russian fires, Canadian floods, US ethanol subsidies or Argentine export controls.

But when virtually all commodity prices move together, it must be macroeconomic:
70s, 80s, 2002-08 , 2008-09, 2009-11. led growth 2002-08 & 2010-11.
as reflected in real interest rates.

Leading explanation: global business cycle, e.g., China Secondary explanation: monetary policy,

GROWTH IN CHINAS IMPORTS OF MINING PRODUCTS IS A BIG REASON FOR THE UPWARD
TREND IN THEIR PRICES.

World Economic Outlook, IMF, April 2012

THEY COULD GO MUCH HIGHER, OR MUCH LOWER.

OIL PRICES HAVE CONTINUED TO RISE IN 2012.

This has been idiosyncratic, not a continuation of the general commodity boom. E.g., natural gas prices are strongly down,
at least in the U.S.

It is attributable to geopolitical risk:

Tensions with Iran.

Sanctions on Iranian oil exports. The danger of military conflict

which might impede access to oil from the Persian Gulf.

COLOMBIA, LIKE MOST LATIN AMERICAN COUNTRIES, IS VULNERABLE TO FURTHER SWINGS IN PRICES OF COMMODITIES ESP. OIL & COFFEE

Dangers of commodity volatility include:

Highly cyclical revenues; Real currency appreciation crowding out manufacturing Procyclical fiscal policy; Procyclical monetary policy.

Risk-manangement recommendations for commodity-exporting countries

CONTRACT DEVICES TO SHARE RISKS
1. Index contracts with foreign companies to the world commodity price. 2. Hedge commodity revenues in options markets 3. Denominate debt in terms of commodity price:
Issue oil bonds & coffee bonds, instead of $ or peso bonds.

Recommendations for commodity producers

continued

COUNTER-CYCLICAL MACROECONOMIC POLICY

4. Allow some currency appreciation in response to a rise in world prices of export commodities,
but not free floating. Accumulate some forex reserves.

5. If the monetary regime is to be Inflation Targeting, consider using as the target, in place of the CPI, a price measure that puts weight PPT on the export commodity (Product Price Targeting).

6. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent commodity price rises.

Recommendations for commodity producers,

concluded

GOOD GOVERNANCE INSTITUTIONS

7. Manage Commodity Funds transparently & professionally,

like Botswanas Pula Fund -- not subject to politics like Norways Pension Fund.

8. Invest in education, health, & roads.

9. Buyers: Publish What You Pay.

ELABORATION ON TWO PROPOSALS TO REDUCE THE PROCYCLICALITY OF MACROECONOMIC POLICY FOR COMMODITY EXPORTERS

I) To make monetary/exchange rate policy less procyclical: PPT Product Price Targeting

II) To make fiscal policy less procyclical: emulate Chile.

REGIME FOR COUNTRIES WHERE TERMS OF TRADE SHOCKS DOMINATE THE CYCLE Floating accommodates terms of trade shocks, thus giving countercyclical monetary policy; but can entail excessive exchange rate movement and does not provide a nominal anchor.

I) THE CHALLENGE OF DESIGNING A CURRENCY

Inflation targeting, in terms of the CPI, provides a nominal anchor; but can dictate a procyclical monetary policy.

Product Price Targeting

PPT

Target an index of domestic production prices. [1]

Include export commodities in the index and exclude import commodities,

so money tightens & the currency appreciates
when world prices of export commodities rise,
not when world priced of import commodities rise.

Automatically countercyclical.

The CPI does it backwards:

It calls for appreciation when import prices rise, and not when export prices rise.
[1] Frankel (2011).
Professor Jeffrey Frankel

45