Capital flows, imbalances, reforms: the emerging trio

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Avelino Hernández
December 5th, 2013

After several years of intense turbulence, it seems as if some of the threats to international financial and macroeconomic stability will finally dissipate in 2014. But not all of them are gone and this is due both to the substance of potential sources of tension and also due to the persistent indications of certain «weak links» that might easily succumb. Among the first, of note is the shift towards normalisation that, sooner rather than later, will be started by the Federal Reserve (Fed). When, last May, Ben Bernanke first suggested that the Fed would move in this direction, the effect on the financial market was widespread and far-reaching. Unexpectedly, the emerging countries were particularly hard hit with capital outflows, currency depreciations and a rise in their risk premium. Could a similar episode happen in 2014? Fortunately, conditions are evolving towards a calmer situation. On the one hand, the factor of surprise should not apply, particularly if the Fed manages to communicate its intentions properly and these are gradual, as seems opportune. On the other hand, a large number of the emerging countries are doing their bit to improve the perception of soundness among international investors. This leads us to believe that not all of them will suffer from this monetary shift to the same degree. Capital flows will presumably discriminate between countries depending on their macroeconomic imbalances and the efforts being made to correct them. It is therefore useful to review the dynamics in the most representative cases.

Since 2008, the monetary policy of the main western central banks has been extraordinarily expansionary. This, together with the difficulties encountered by the euro area, led to massive flows of capital towards emerging economies. The higher yields on investments in these countries and a much healthier set of vulnerabilities than at the end of the 1990s made them the favourite destination among the international financial community, with the consequent risk of a «boomerang effect» typical of more speculative portfolio flows. The overabundance of liquidity boosted growth in credit in numerous emerging economies, causing or exacerbating external and internal imbalances everywhere. Among the first, of note was the deterioration in current account balances in some of the large countries, in particular the «Fragile Five» (Brazil, India, Indonesia, Turkey and South Africa), whose currencies were hit particularly hard by the storm last summer. Internal imbalances can be classified into two major groups: asset bubbles and excessive debt. For example, of concern is the rising price of housing in Beijing and the large coastal cities of China, as well as in São Paulo and Río de Janeiro in Brazil. With regard to increasing debt, there are examples both in the public and private sphere. India is the paradigm of a recurrent fiscal deficit, accumulating a worrying level of public debt and with a very heavy burden of interest payments. The rapid deterioration in South Africa's fiscal balance is also worrying. On the other hand, China is the country whose private debt has risen the most but large increases have also been notable in Brazil, Turkey, Poland and Russia. In short, doubts surrounding the emerging countries have surfaced sharply after the aforementioned messages from the Fed.

However, the difference in 2014 is that many of those economies have undertaken processes of reforms that will be crucial in correcting such external and internal imbalances. The list is long. Undoubtedly, the news coming from China after the Third Plenary Session of the CPC Central Committee, under the new leadership of Xi Jinping, takes pride of place. Although the details are still unknown, the strategic orientation consists of granting a more decisive role to market forces. Among the main lines of action are a more open stance towards foreign investment, increasing the relevance of the private business sector, modernising and liberalising the financial sector (which will entail greater flexibility in the exchange rate regime), and administrative, fiscal and rural-urban reforms. An ambitious plan that, should it be completed, will result in significant and sustainable advances in the medium term. In the short term, the considerable room for manoeuvre of the Chinese government to adopt expansionary measures (of a monetary or fiscal nature) means that we are optimistic regarding the country's growth prospects.

Mexico also occupies a notable place due to its ambitious programme of structural reforms, started at the end of 2012. After approving reforms in the areas of labour, education, telecommunications and finance, this November it was the turn of fiscal reform, although this is admittedly rather decaffeinated. On the other hand, far-reaching energy reforms are to be expected, eliminating the current investor restrictions in the sector and boosting the country's potential growth in the medium term. In the short term, and after a slowdown in the first half of 2013, the economy will build up steam, supported by the improvement in the USA (a country that absorbs 80% of its exports) and expansionary fiscal and monetary policies.

For its part, India is one of the economies facing the greatest challenges: it must strengthen its weak manufacturing sector in order to correct the high and growing current account deficit, and also needs to carry out significant fiscal consolidation without forgetting investment in infrastructures (vital to relieve the bottlenecks that are throttling growth). All this within a context of inflationary pressures that refuse to die down. Given this complex situation, it comes as no surprise that its currency suffered a sharp depreciation this summer. In addition to the size of its imbalances, another factor going against India in the race to attract investors is the difficulty in achieving stable political coalitions that provide continuity to the economic restructuring plans, particularly given the impending legislative elections next May. Nonetheless, recent actions taken by the renovated monetary authority to put a stop to inflation, cuts in subsidies for diesel prices and the announcement of a new tax on goods and services are significant steps in the right direction. If, after the elections, this reformist drive continues as well as the assurance shown in adjustment policies, international investors will probably be convinced by the attractive prospects presented by India in the medium and long term.

Brazil must also tackle significant challenges: improving the business environment so that the private sector can contribute more to growth, liberalising the labour market and generating fiscal space to be able to increase investment in logistic and energy infrastructures. But, unlike the countries mentioned so far, its reformist efforts are not enough. This is partly due to the misleading and counterproductive effect caused by the inertia still being shown by strong growth in the past, with the help of expansionary fiscal policy (within the context of the football World Cup and given the elections next year). The risk is that social unrest and electoral pressure will push public policies too far towards social and protectionist positions in detriment to efficiency and potential growth in the long term. This could undermine the confidence of international investors.

Turkey was also hit hard by the markets due to its high macroeconomic imbalances (especially inflation and its current account deficit). Although it is vital for the Turkey to reduce its high dependence on other countries, this will not be easy to achieve given its complex political situation. In the short term, the likely scenario is a progressive tightening up of monetary policy, administrative restrictions on credit and a fiscal policy that is nevertheless slightly more expansionary. As a result of these actions, activity will probably slow down between the end of 2013 and the middle of 2014, but a gentle recovery is expected from then on. In any case, until economic readjustment is well on its way and a recovery can be seen, Turkey runs the risk of being identified as one of the «weak links» in the international arena.

Lastly, conditions are positive in Russia: its comfortable current account surplus and balanced public accounts provide a valuable safe margin in the case of increased global risk aversion. Nonetheless, in the medium term there is a growing risk of a sustained decline in potential growth due to the combination of a certain lack of will to reform (particularly in the area of institutional changes) and one of the most adverse demographic patterns among the emerging countries (the working age population is expected to fall due to the low birth rate).

In short, the map of imbalances and the efforts being made to correct them vary widely throughout the emerging world. On the whole, the panorama is evolving reasonably satisfactorily and is likely to be able to withstand an environment of less global liquidity, thereby fulfilling Mark Twain's saying that history never repeats itself (but it rhymes).

Clàudia Canals and Avelino Hernández

International Unit, Research Department, "la Caixa"

Avelino Hernández