GLOBAL ECONOMICS FOCUS

Emerging markets will not rescue the rest of the world
Emerging market economies will continue to grow rapidly over the next few years. But with current account surpluses in most of Asia and among oil producers likely to remain high, this will not be of much benefit to the developed world. What’s more, while some emerging economies are likely to become an increasingly important source of global demand, there is a growing risk of asset bubbles, with Latin American countries looking particularly vulnerable. We think emerging economies will grow by an annual average of 6% over the next two years – roughly four times as fast as the G7. But for this rapid growth to pull the developed world out of its rut there would have to be a significant expansion in import demand from the likes of China and the oil producers. Put another way, the emerging world’s current account surplus needs to fall. In the near term, at least, this seems unlikely. The draft outline of China’s forthcoming five-year plan puts a heavy emphasis on the need to boost domestic demand. But, on the ground, imbalances are rebounding and powerful vested interests are likely to frustrate efforts at rapid reform. The prospects for rebalancing elsewhere in Asia are better but even so it will still be a slow process. And unless commodity prices fall sharply, the oil producers’ surpluses look here to stay too. Admittedly, other parts of the emerging world are likely to boost global demand over the coming years. The likes of Brazil, Mexico, Poland, Turkey and some smaller economies in Eastern Europe and Latin America all have huge investment needs. But at the same time domestic savings in these countries are very low. One way to finance a much-needed pick-up in investment is therefore to borrow from economies with excess savings – in effect running current account deficits that could at least in part offset the surpluses of Asia and the oil producers. But while this could provide a degree of support for the developed world, it is unlikely to have much impact if the surpluses of Asia and the oil producing nations remain large. There are also risks – notably of overheated growth and asset price bubbles in emerging market deficit economies. The upshot is that the developed world will not be able to rely on emerging markets to pull it from its current malaise. Instead, we are facing a period in which emerging markets grow relatively strongly while the G7 recovery is slow. This could be a combustible mix as G7 policymakers ask whether their emerging world counterparts should not be doing more to expand global demand. Mark Williams & Neil Shearing Tel: +44 (0)20 7808 4985 North America 2 Bloor Street West, Suite 1740 Toronto, ON M4W 3E2 Canada Tel: +1 416 413 0428 Managing Director Chief International Economist Senior Emerging Markets Economist Senior China Economist Europe 150 Buckingham Palace Road London SW1W 9TR United Kingdom Tel: + 44 (0)20 7823 5000 Asia #26-03 Hitachi Tower 16 Collyer Quay Singapore 049318 Tel: +65 6595 5190

Roger Bootle (roger.bootle@capitaleconomics.com) Julian Jessop (julian.jessop@capitaleconomics.com) Neil Shearing (neil.shearing@capitaleconomics.com) Mark Williams (mark.williams@capitaleconomics.com)

8th Nov. 2010
Global Economics Focus 1

did not do much to support economies in the high-income world.0 1. In contrast to the developed world.5 92 94 2. Their combined surplus peaked in 2007. CHART 1: GDP (MARKET EXCHANGE RATES. the 4 2 0 -2 -4 Sources – CEIC.5 1. SAFE 2 Global Economics Focus .0 -0. China’s current account surplus has more than halved to around 5% of its GDP since the peak.5 0. % Y/Y) 10 8 6 4 2 0 -2 -4 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10F Emerging and developing economies Advanced economies 10 8 6 4 2 0 -2 -4 emerging world’s surplus declined because export demand collapsed.) Clearly a lot of that “rebalancing” was involuntary. (See Chart 2. Last year the surplus had fallen by about a third as a share of world GDP. the major emerging world surpluses could be divided into three roughly equal parts: China.) Of course. But hopes that this might develop into a lasting rebalancing of the Chinese economy have already been dashed. Fast GDP growth in emerging markets is nothing new – the emerging world has outperformed by a wide margin for about a decade now.0 1. partly to fuel stimuluslinked investment.0 -0. the rest of Asia and the oil exporters (taken here to be OPEC plus Russia). CHART 2: CURRENT ACCOUNT SURPLUSES (% WORLD GDP) 2.0 0. the major emerging economies are already back to business as usual and look set to grow substantially faster than the West for the foreseeable future. Exports plunged. Over the next few years the hope must be that the surpluses will continue to come down due to stronger demand within emerging markets. (See Chart 3. This Focus asks whether the likes of the US and Europe will benefit from this growth.5 1. This is because emerging market exports have grown by much more than imports. So when we look ahead we need to bear in mind that rapid growth in emerging markets will only help the developed world if that pattern changes – and the emerging world’s current account surplus falls.0 0.5 Oil Producers 2. Capital Economics How did we get here? In the years running up to the crisis. rapid growth.5 96 98 00 02 04 06 08 10 Source – IMF Is China already rebalancing? What are the chances that the surpluses continue to fall? We will start with China.) But for most of that period. There was also a big increase in imports.5 0. before moving onto the other regions. particularly in Asia.5 China Other Asia 2. (See Chart 1.Emerging markets will not rescue the rest of the world This Focus is an adapted version of a presentation given at the Capital Economics Annual Conferences in Europe and North America in September and October 2010. so that their rapid growth is positive for the rest of the world. CHART 3: CHINA CURRENT ACCOUNT SURPLUS (% GDP) 12 10 8 6 12 10 8 6 4 2 0 *Official estimate for 1H 2010 -2 -4 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10* Sources – IMF.

the government would have to scrap the incentives that currently channel income into profits and the incomes of the richest households – where they tend to be saved – rather than the wages of average workers. SEAS. For example.) CHART 4: CHINA TRADE SURPLUS ($BN. an extremely low level that has actually fallen over the past decade. for example. In fact the surplus is already almost as big now as it ever was. (See Chart 6. ADJ. and the implicit subsidy of the exchange rate. The government can stimulate spending in the short term.) 40 30 20 10 0 -10 00 01 02 03 04 05 06 07 08 09 10 11 Monthly surplus 3m average 40 30 20 10 0 -10 going into reverse. the long-awaited acceleration in consumer spending that would be needed to bring down the surplus at current levels of output growth has not materialised. many of them state-owned. According to Income growth still weak So China’s economy has not rebalanced that far and what rebalancing we have seen is already Global Economics Focus 3 . getting rid of subsidies on energy and land. but a sustained pick-up in household spending growth is much harder to bring about because the roots of weak consumption (relative to production) are in the very structure of the Chinese economy.) 140 120 100 80 60 40 20 0 -20 -40 50 1992 1994 1996 1998 2000 2002 2004 2006 Household consumption (RHS) 40 35 30 Source – CEIC Source – Thomson Datastream In practice. have prospered from access to cheap loans.) In order to reverse this shift. This shouldn’t be a surprise. and. Last year’s spurt in growth of car sales has rapidly died away. adj. In other words. Chinese households take home little more than half of national income. This would mean. The recent third quarter GDP breakdown demonstrates how far there is to go. These vested interests make it hard for the government to undertake any meaningful reform. Sales growth is back below the pre-crisis rate in y/y terms.The global recovery in exports has brought a rapid rebound in the trade surplus. CHART 5: CHINA AUTO SALES 65 45 60 Household income (LHS) 55 140 120 100 80 60 40 20 0 -20 -40 01 02 03 04 05 06 07 08 09 10 % y/y % 3m/3m (seas. The fundamental issue is how little of China’s income ends up in the pockets of its workers. ramping up interest rates so that more investment goes into labour-intensive sectors. as Chart 5 shows. They will fight to hold on to those advantages. breaking up the stateowned monopolies. allowing the currency to rise. There were a lot of stories earlier in the year contrasting the strength of Chinese consumption with the weakness elsewhere. But. the hopeful signs that Chinese consumer spending was accelerating are already fading. China recently overtook the US as the world’s largest market for cars. of course. energy and land. CHART 6: CHINA HOUSEHOLD INCOME & CONSUMPTION (% GDP) 70 50 Sources – Thomson Datastream This turnaround is not just about the global rebound though. (See Chart 4. big firms.

But the government is clearly not eager to speed up that rebalancing.2 8. it took on average the best part of half a year to start a business in Indonesia. For emerging Asia outside China.8 8. That is now down to a couple of months. one retiree at a time.6 7. As Chart 8 shows. The situation is somewhat different in the rest of Asia.6 6. The improvements are less dramatic elsewhere in the region.8 8. For example. on the following page.6 6.8 7.) CHART 7: RENMINBI/DOLLAR EXCHANGE RATE (INVERTED) 6. But. The government did loosen its control over the renminbi earlier this year. again.) 4 Global Economics Focus . Asian households outside of China consume only a little less as a share of national income than those in the G7.2 8.China’s statistics bureau. (See Chart 7. as we can see from the recent intervention to keep the yen down.0 7. The ageing of Japan’s population is gradually bringing down the surplus. (See Chart 10.6% y/y last quarter but real urban disposable incomes rose only 7.2 7. governments in the rest of Asia do now seem to be trying to improve matters.2 7. surpluses are already reappearing. Even the modest pace of appreciation seen over the past few weeks is likely to slow once the upcoming G20 Summit is out of the way.0 8. particularly when the dollar has been weakening more sharply against the euro and yen. but you can see from Chart 9 that these countries are all moving in the right direction. Korea’s current account surplus is now about as big in dollar terms as it has ever been.0 7. OF DAYS NEEDED TO START A BUSINESS 180 150 120 90 60 30 0 2004 2010 180 150 120 90 60 30 0 Source – Bloomberg More promising signs elsewhere in Asia So seems little prospect China retooling its economy to be led by consumers quickly enough to help rescue the developed world from its current malaise. CHART 9: NO.6 7.4 CHART 8: HOUSEHOLD CONSUMPTION (AS A % OF GDP) (2008) 80 70 60 50 40 30 20 10 0 G7 Average 80 70 60 50 40 30 20 10 0 Source – Thomson Datastream When it comes to investment. But the 2% gain we have seen against the dollar since then can hardly be described as a dramatic shift in policy.4 2007 2008 2009 2010 Renminbi stronger 'Dramatic' Policy Change 6. the growth of current account surpluses since late 1990s has been not so much about a surfeit of saving as relatively weak investment and the desire to build up precautionary stocks of foreign exchange reserves. as recently as 2004. real GDP grew 9. this is a process that will play out over several years.8 7. Just as with China. Source – World Bank In the meantime. Stronger investment should follow which will bring down current account surpluses.4 7.4 7. Households still seem not be sharing equally in the spoils of growth.0 8.5%.

Source – Thomson Datastream Korea illustrates the wider trend. Oil prices to fall. For this reason we expect oil surpluses in general to remain high. And the country also has its own symbolic significance as the chair of the G20 – the body that has been issuing clarion calls for surplus nations to boost domestic spending. a sharp fall in commodity prices would have some downsides. Such a shift would not be unprecedented.CHART 10: KOREA CURRENT ACCOUNT BALANCE ($BN.8 0. ADJ. raising the risk of a deflationary spiral. A further fall to $40pb is possible if supply improves more rapidly than anticipated. economies heavily dependent on commodity exports would obviously suffer as well. That seems unlikely unless there is a collapse in global demand. high levels of unemployment in the Gulf region might encourage governments to raise spending. the oil producers experienced the biggest falls in surpluses last year because lower demand for oil was compounded by a big drop in prices.4 0. Oil producers moved very rapidly from surplus to deficit in the 1970s. Meanwhile. Perhaps the strongest argument for oil producers to save rather than spend oil proceeds is that the oil won’t last forever. RHS) 100 F'cast 80 60 40 Sources – IMF. But at that level. the chart implies that the oil producers would still have large surpluses.0 0.2 92 94 96 98 00 02 04 06 08 10 12 20 0 OPEC+Russia current account surplus (% world GDP.0 -0. oil prices would have to fall to something like $20pb or below for the oil producers surpluses to be brought into balance. Will the oil producers start to spend? Of course it is not out of the question that the oil producers start to spend their income in a way that they didn’t over the last decade. CHART 11: OIL PRICE & OIL PRODUCER SURPLUSES 1. What’s more. Capital Economics Global Economics Focus 5 . But that experience ended badly with much wasted investment and consumption that proved to be unsustainable when prices dropped back. Even at the depths of the financial crisis. thus helping the global recovery. so it boosted demand at the global level. Headline inflation would probably turn negative in the major economies. In other words.6 0. It makes sense to save for the days when it runs out. who are big savers. Thomson Datastream. SEAS. For example. but not far enough Moving on. this will still take time. Even if we are right to be more optimistic about rebalancing in Asia outside China. MONTHLY. the oil price remained well above $30pb. oil producers have a much better claim than Asian governments that surpluses are in their people’s interests. But as Chart 11 suggests. This would take them back to the levels before prices took off in 2007.) 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 Our central forecast is that oil prices will drop back to around $60 per barrel from today’s $80 or so and then stay there.2 1.) The adjustment in prices had the effect of redistributing income from producers. (See Chart 11. LHS) Oil price ($pb. Any substantial fall in prices will tend to feed demand and thus act as a stabilisation mechanism. to consumers who tend to spend more of their income. This suggests that a prolonged period of low prices would be one way in which the oil producers might be brought into balance. annual average.2 0.

That inevitably means it will happen slowly. they would have to expand small deficits. Producers of other commodities tend not to have large surpluses. we doubt that the developed world will be able to rely on rebalancing in Asia or among the commodity producers to boost demand over the next few years. the result for the G7 would be just the same: smaller external deficits and stronger growth. Russia’s exit from the world’s super savers will have important implications locally. Countries such as Mexico. In particular. rather than reduce large surpluses. But for producers of soft commodities and metals. Asia & the oil producers unlikely to boost demand Bringing this together. will start to come down and even shift into deficit in the next few years. Not only are these small economies – we’re talking about places like Malawi. Sources – UNCTAD. the government will have to reform the business environment and strengthen property rights if Russia is to attract the capital the country needs to develop. In the end. What about the rest of the emerging world? One group of countries we have not mentioned so far are those large emerging markets that don’t have big surpluses.The exception is perhaps Russia and there is a good chance that its surplus.) But at the same time. it might be demographic change that brings China’s surplus down to earth. domestic savings rates in these countries are low. Might these countries become a meaningful source of global demand? To do so. shifts in the prices of non-oil commodities do not in general have any impact on global savings. Turkey and Brazil all have huge investment needs. the current account will slip into negative territory too. What’s more. CHART 12: CURRENT ACCOUNT SURPLUSES OF NON-FUEL COMMODITY PRODUCERS (% GDP) 40 30 20 10 0 -10 -20 -30 -40 Countries with non-fuel commodity exports > 20% of GDP 40 30 20 10 0 -10 -20 -30 -40 In other words. At present investment is well below the 25% of GDP widely considered to be the benchmark for emerging economies and which most Asian emerging economies easily surpass. places like Brazil and Mexico. Chart 12 shows all countries for which non-fuel commodity exports are equivalent to more than 20% of GDP. So unless oil prices surge back towards $100pb.1% of world GDP. But it will not do much to help the world economy – we estimate the swing in Russia’s current account balance over the next few years will be equivalent to just 0. We are more optimistic about the prospect for change elsewhere in emerging Asia. there are strong arguments from a domestic point of view when you look at places like Brazil and Mexico why these countries might want to run bigger deficits in future. Poland. The key difference is that the vast bulk of last year’s fiscal stimulus in Russia took the form of socalled permanent measures – such as increases to state pensions and public sector wages. But in the absence of a very sharp drop in commodity prices. but other things being equal. the pot of funds from which investment can be financed domestically is much smaller than in the likes of China and India. deficits are about as common as surpluses. As a result. So far. Russia’s budget deficit is here to stay – and as the private sector slowly starts to find its feet. they simply shift income from one group of consumers to another. the surpluses of the oil producing nations look here to stay. (See Chart 13 on the following page. We suspect that the Kremlin will find it hard to turn back from these spending commitments. Capital Economics 6 Global Economics Focus . which is about a fifth of the oil producers’ total. we’ve only discussed the oil producers.

Mexico. Bubbles inevitable in some emerging markets But there is also the potential for greater volatility. this will probably happen over the next decade or so as per capita incomes rise and recent improvements to policymaking (notably a transition to inflation targeting) gain traction. while equity markets in some corners of the emerging world such as Colombia are already looking frothy. for example limiting pension provisions.CHART 13: INVESTMENT (% GDP. This leaves the alternative of funding investment by borrowing from overseas. But that’s not really so. or at least not when you look at them in aggregate. A reliance on external funding would make the macro economy vulnerable to sudden shifts in investor sentiment. Rather than being channelled into improving productive capacity. the persistence of surplus savings in other parts of the emerging world offers a relatively painless way to finance a boom in investment. Capital Economics This leaves policymakers with two options. 2009) 15 12 9 6 3 0 China Other Em. House prices in parts of Brazil have surged recently. Asia Japan "Deficit EMs"* US * Deficit EMs = Brazil. In fact. as long as the surpluses of China and the oil producers Global Economics Focus 7 . The good news is policymakers in most emerging economies are aware of the risks. Mexico. At the same time though. One is stronger emerging market growth in the recipient countries as a pick-up in investment pushes up the sustainable growth rate. but must be complemented with further macro-prudential measures to limit the damage to the financial system and economy when bubbles burst (as they inevitably will). Turkey & Poland 15 12 9 6 3 0 Sources – Thomson Datastream. then. CHART 14: GDP ($TRN. Unfortunately most of these measures would be hugely unpopular. you only have to look at the events of the past couple of years to see how difficult it is for countries to regulate both the Source – IMF Our potential emerging market deficit countries are Brazil. We think this shift is worth monitoring closely and it has some interesting investment implications. in effect running current account deficits that could at least in part offset the surpluses of Asia and the oil producers. Poland and a few smaller nations in Eastern Europe and Latin America. (See Chart 14. there is a risk if these countries embrace inflows from Asia that they inflate asset price bubbles – indeed this may already be happening. The first is that they raise domestic savings. Moreover. Turkey. 2009) 50 40 30 20 10 0 EM benchmark 50 40 30 20 10 0 quality and quantity of capital inflows. The bad news is that it is asking an awful lot to expect that some of the more sophisticated reforms that are necessary will be implemented. But this will be a gradual process and a sizeable increase in savings is unlikely without further reform. Capital controls are back on the agenda.) So we should not dismiss them out of hand. Can the G7 benefit? How relevant is all of this to the developed world? The initial assumption is that these economies in Latin America and Eastern Europe are too small to substantially boost developed world exports. Together their GDP is not much smaller than China’s. For some emerging markets. introducing forced savings schemes or tightening fiscal policy.

the deficit emerging economies are not large enough as a group to provide much of a boost in demand to the developed world. A new leadership will also take power in China in 2012. we are confident that emerging markets will continue to grow rapidly over the next few years. a lurch into protectionism remains a major threat for the emerging world. Another is that our view on rebalancing proves over-optimistic and that rather than broadly stabilising.remain high. However. the incumbent government’s capacity to push back against vested interests is fading. It could easily all turn rather ugly. As long as G7 economies are struggling. In the meantime. We think that some emerging market deficit countries could provide a degree of support to the developed world. this already seems to be happening. The political cycles in the US and China add to the dangers. there is the growing threat of protectionism. Finally. Summary In conclusion. One is that capital flows within the emerging world feed asset price bubbles and raise macroeconomic vulnerability – indeed. there are also risks. the emerging world would be a drag on developed economies. the surpluses continue to increase. The US economy on its own is about four times their size. in which case. A prolonged period of weak growth and high unemployment in the West while emerging markets are growing much faster is potentially a volatile mix. but we do not believe this will be of much benefit for the developed world. Asian and oil producer surpluses look likely to stay high unless China embraces structural reform much faster than seems likely or oil prices collapse. The US holds presidential elections in 2012. 8 Global Economics Focus .

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