Emerging economies slowing down

This column was first published in the May edition of Fund Strategy.

A disturbing new tag has become attached to the emerging world in recent months. The term “fragile five” has started to compete with Brics and Mints as a label for a distinct group of developing economies.

Morgan Stanley is usually credited with coining the term in a paper published in August 2013. It referred to the five EM economies with large current account deficits – Brazil, India, Indonesia, South Africa and Turkey – which had recently suffered market turmoil. Their currencies had fallen, stockmarkets plummeted and bond yields surged.

Although the term was new, the initial talk of tapering by the US Federal Reserve last May precipitated much of the concern. The fear was that the Fed’s tightening of monetary policy would attract capital back to the US from the emerging world. As a result, countries with large current account deficits would suffer.

After the initial damage, the Fed moved to reassure the markets. It emphasised that tapering meant a gradual slowdown in the rate of quantitative easing rather than an end of its easy money policy.

Nevertheless, the Fed had inadvertently highlighted the vulnerabilities of key emerging economies. Each one had to hike interest rates to stabilise the markets and all face challenges with elections due this year.

This is a long way from the upbeat view of EM economies exemplified by the talk of Brics (Brazil, Russia, India and China) since Jim O’Neill of Goldman Sachs coined the term in 2001. The label was never just about those countries themselves; it helped convey the idea that the EM economies as a whole were growing more rapidly than the developed world. The more recent use of the term Mints was meant to apply this optimism to a second tier of large – as opposed to gigantic – economies: Mexico, Indonesia, Nigeria, Turkey and South Africa.

The sharp-eyed will have noticed some overlap between the fragile five and the other two categories. This suggests two related trends rather than one distinct development. First, growth in the EM world as a whole is slowing down. IMF figures show that GDP growth in those countries fell from 7.5% in 2010 to an estimated 4.5% in 2013 – the lowest since 2001 apart from a dip in 2009 following the global crash.

Even China seems to have lost its edge, recently announcing a GDP growth target of 7.5% for 2014 – substantially below the average rate in recent decades.

But the Chinese economy is in better shape than those of the fragile five, having long enjoyed a current account surplus. This contrast points to the second key trend – some developing countries seem to have acquired major structural problems. They are not just suffering from contagion as a result of unwise comments from the Fed. More fundamental forces are at work.

A recent paper by the Federal Reserve Bank of San Francisco (FRBSF Economic Letter, 3 March 2014) highlighted this development, noting that “a country’s domestic economic conditions, together with its relative internal and external imbalances, are likely to have influenced the relative severity of retrenchment in capital flows following the news about Fed tapering”.

Indeed, the importance of internal domestic factors was already hinted at in the earlier Morgan Stanley paper. According to author James Lord: “Currencies will be held back by high inflation, large current account deficits, challenging capital flow prospects and potentially weak EM growth. The prospective normalisation of Fed monetary policy simply exacerbates these underlying fundamental weaknesses.”

If anything, these two authors understated the challenges facing the emerging world. External volatility originating in developing countries has merely added to their problems.

This is bad news for the global economy, pointing to lower growth overall and the potential for high volatility in some markets. It looks like a bumpy ride ahead.