Editorial


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December 2012

Editorial

Very soft landing

Portfolio investments: artificially strong

The economic growth slowdown in emerging countries extended into Q3 2012 as most activity indicators suggested through early summer. Yet the slowdown proved to be much milder than feared given the downturn in manufacturers’ sentiment (as reported by PMI surveys). Aggregate real GDP growth for the 27 countries in our sample is estimated at 4.6% year-on-year in Q3 2012, down from 4.9% in Q2 2012. In other words, the pace of the slowdown has not changed since mid 2011. Moreover, PMI surveys have picked up since August, notably the export orders component, and as of September, industrial production began to level off and even to recover. At the same time, inflationary pressures have remained mild, despite the surge in agricultural commodity prices over the summer. Aggregate inflation for emerging countries was only 5% year-on-year in Q3, with core inflation of 3.6%. Several central banks continued to lower their key policy rates (for example in Brazil, Hungary, Thailand…) and monetary policy will probably continue to support growth longer than expected in mid 2012.

Since August, there has been a strong upturn in foreign portfolio investments in emerging markets. According to EPFR, subscriptions to dedicated emerging-market equity and bond funds amounted to USD13.1 bn between August and November compared to USD4.0 bn between April and July. Investors favoured bond funds in particular. Issuance of emerging-market corporate bonds has also remained very strong (with the exception of emerging Europe). Occasional sovereign borrowers – either investment grade (Morocco) or non investment grade (Bolivia, El Salvador, Mongolia, Zambia) – easily tapped the international bond market over the last months. For some of them, investors have been willing to overlooked political risks in order to secure yields. For investment-grade borrowers, the cost of financing in dollars is now lower than it was prior to 2008. To a certain extent, this strong rebound in portfolio investment inflows is somewhat artificial because it is fuelled by liquidity provided by the central banks of advanced countries. Moreover, it can force the central banks in emerging countries to intervene in the foreign exchange market to limit the appreciation of their currency.

By region, the Central European countries continue to be outpaced by Latin America and Asia, which are buoyed by their respective champion (Brazil and China) and by US growth. The Polish economy continues to slow down and will no longer offset recession in Hungary and the Czech Republic and virtual stagnation in Bulgaria and Romania. In this region, corporate and household debt reduction continues to be a severe constraint, although according to the IIF survey of financing conditions in Q3 2012, the region’s banks reported an improvement in external financing conditions (thanks probably to liquidity provided by the ECB via OMT). In fact, it is credit demand that is sluggish. At the same time, the increase in non-performing loans erodes bank profitability and liquidity, thereby straining credit supply. In Latin America and Asia, credit is generally slowing but remains a growth engine. In Asia, intra-regional cross border bank financing has more than offset the withdrawal of eurozone and Swiss banks (according to BIS statistics).

The attractiveness of emerging bond markets necessarily makes the structure and cost of government refinancing more vulnerable to domestic and external financial stress. For instance, the share of public securities held by non-resident investors has become very high for countries like Peru and Malaysia, which so far were not listed among the most vulnerable countries. Yet the trend that needs to be watched closely is rather the greater ability of the private sector to resort to external debt. For the moment, the risk is masked by the tendency of sovereign borrowers to substitute localcurrency debt for foreign-currency debt, and thus on the whole (public and private borrowers combined), the external solvency of emerging countries is improving. This was effectively the case until 2011, based on external debt and/or debt servicing ratios. Yet this trend could come to an end, or even reverse itself.

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December 2012

Political risk: arbitrary decisions are back The most striking development in the emerging market universe over the past six months is the increase in political risk in the broad sense of the term, i.e. including the deterioration in the business environment due to arbitrary government acts. This is not a widespread risk but one that has been confirmed or is worsening in a number of previously identified countries, which have been weakened by the current slowdown or recession. We can divide these countries into two groups. The first comprises the so-called Arab Spring countries, which are characterised by an increase in internal political risk (Egypt, Tunisia). This is notably the case in Egypt, where until summer, the political transition seemed to be unfolding smoothly without major confrontation (notably between the Muslim Brotherhood and the army). But then President Morsi assumed virtually all powers in order to push through the legislative process, which sparked a major protest movement in recent weeks (see page 25). Political risk has also increased sharply in Iran, where the economic situation is verging on collapse, strangled by growing international pressures and isolation. The second group of countries comprises Argentina, Hungary and Ukraine. The common characteristic of these countries is the resistance of their governments to pressures from financial markets and/or international financial institutions. For Argentina and Hungary, this resistance takes the form of heterodox economic policy measures (forex controls, government influence on central bank decisions, import restrictions, privatisation and exceptional taxes on key sectors) to deal with deteriorating public finances or weakening foreign reserves. These measures are also part of a strategy to promote economic nationalism. In Ukraine, the government keeps putting off an agreement with the IMF by staking its hopes on its capacity to borrow on the international markets. In all three cases, the governments are playing with fire because they face severely deteriorated domestic macroeconomic situations and have rather limited foreign exchange reserves. This has strongly increased non-transfer risk (which has materialised in Argentina) as well as the risk of a sovereign default on foreign-currency debt.

François Faure [email protected]

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