Monday, June 30, 2008

How vulnerable are EMEs to a slowing US economy?

The U.S. economy plagued by the double whammy of a strong downturn in the housing market coupled with substantial stress in financial markets, is at the brink of a severe collapse of aggregate demand. One of the few positive developments during this downturn was strong export growth related to strong global demand. In light of that lifeline emerging market economies (EMEs) represent to the developed economies one can't help but wonder how vulnerable EMEs are to the much anticipated slowdown in the U.S. economy.

By looking at history the experience of the US slowdown in 2001 has shown that the downside risks for EME growth can be substantial. The collapse of the high-tech boom led to a 2 percentage points below average growth in the US, at the same time import growth fell 15 percent below average. Exports in EMEs were hard hit and China suffered a decline in its growth rate of 0.6 percentage points for every 1 percent drop in US growth. However the current episode seems to be different from the experience of the 2001 recession at least thus far. The Bank of International Settlement in his most recent Annual Report, cites mainly two reasons for a possible gradual decoupling of the business cycle in EMEs from the U.S.

from the report:
In contrast, the recent US slowdown appears to date to have been associated with a much smaller decline in EME growth. Indeed, although slowing, EME growth has remained above average (Graph III.12, bottom left-hand panel) as US growth has faltered.

Two explanations can be offered for these differences in growth performance across the two periods. First, in contrast to 2001, emerging market exports continued to grow above their average rates in 2007 (Graph III.12, bottom right-hand panel), even if US import growth was below average. However, as discussed below, the risk of a more severe outcome nonetheless remains. Second, EMEs have recently been able to counter the effects of any fall in demand for their exports by boosting their domestic demand more than in 2001 (Graph III.1, blue circles). Compared to 2001, private consumption spending has risen more strongly in emerging Asia and Latin America. The contribution to growth of investment spending (red circles) switched from negative in 2001 to a strong positive for Asia, Latin America and central Europe in 2007. Thus, there seems to be some growth momentum for domestic demand in most emerging market regions. This may partly explain why, in spite of increasing globalisation, research shows that the impact on EMEs of economic activity in advanced industrial economies has declined.

click to enlarge
The 0-line at the lower half of the chart indicates trend line growth from 1998 to 2007, with the different economies deviating from average annual growth in percentage points. Although growth in nominal exports in EMEs stayed above trend during 2007 exports from China and Latin America have recently turned lower. The consensus forecast of continued growth in EMEs despite a substantial slowdown in US growth has to be taken in with a grain of salt. Forecast usually miss business cycle turning points. Thus, if global developments were to cause a severe downturn in EMEs, it is possible that consensus forecasts would not predict it.

In case that this grain turns out to be more salty than forecast EMEs face three major challenges as the

BIS report lists them:

First, emerging market exports might weaken, possibly more than predicted by recent consensus forecasts. Second, there may be constraints on EMEs’ ability to boost domestic demand to compensate for any weakening in exports. Third, EMEs with high current account deficits and high short-term debt, as well as those that rely heavily on cross-border bank financing, may be vulnerable to reversals of capital flows.

The next graph about China's import developments eases but does not completely dispel such concerns of a severe slowdown in EMEs. Imports for ordinary trade, which is closely related to China's domestic demand, have increased from September 2007 to February 2008. At the same time imports for processing trade, which is directly linked to China's exports, have decreased indicating that at least to some degree domestic demand can make up for a shortfall in external demand. The risk of a slowdown in domestic demand as a result of a marked slowdown in the US economy is highlighted by China's ordinary trade imports which took a steep dive in March. As the chart below demonstrates this slowdown in China's domestic demand is felt all over the globe, in particular in the U.S. and Latin America to a lesser degree in the rest of Asia. Chinese import growth never led to the equivalent growth of exports in its Asian trading partners as compared to the relatively strong growth with Latin America and oil-exporting countries.

click to enlarge

The last chart highlights the vulnerability of EMEs to capital flow reversals. Although EMEs as a whole appear less vulnerable today a severe downturn in the US could test this assumption and prove it wrong. The BIS has identified two types of vulnerabilities and highlights of external vulnerability indicators can be found in the chart below.

Despite some tightening of external financing conditions, the EMEs as a whole – with improved fundamentals, abundant reserves and large current account surpluses – appear to be less vulnerable to reversals in capital flows today than they were in the past. Nevertheless, two types of vulnerabilities to such reversals can be highlighted. First, EMEs with large current account deficits and a high proportion of short-term foreign debt could find it difficult to secure foreign funding if global financing conditions were to tighten more severely. Second, emerging market countries that depend heavily on cross-border bank financing are vulnerable to a withdrawal of such financing due to problems in banks both in advanced industrial economies and at home (see Chapter VII).

Countries that might find it particularly difficult to secure foreign funding if global financing conditions were to tighten further can be identified in the Baltic and southeastern European regions. These countries have very large current account deficits, only around half of which are covered by FDI, usually considered the most stable form of foreign financing (Table III.4). They are also burdened with a high proportion of short-term external debt (120% of foreign exchange reserves on average). Furthermore, cross-border loans in these countries account on average for 76% of domestic credit. South Africa, with a current account deficit of more than 7% of GDP and a high reliance on portfolio inflows, is also in a relatively vulnerable position.

click to enlarge

source: III. Emerging market economies
BIS 78th Annual Report, 30 June 2008

No comments: