POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise JUN 2012 SEPTEMBER 010 • Numbe 87 • Number 18 72313 The New Financial Landscape: What It Means for Emerging Market Economies Otaviano Canuto, Catiana García-Kilroy, and Anderson Caputo Silva As the year 2012 unfolds, its main legacy will be its game changing impact on global financial markets. Waning global growth along with central banks’ bold monetary easing policies in advanced economies (AEs) to try to reverse it are changing market dynamics in unexpected ways, across both AEs and emerging market economies (EMEs). The combina- tion of monetary stimulus, fiscal austerity and hesitant structural economic policy reforms in AEs, particularly in Europe, is taking the global financial system into increasingly uncharted territory. How the European Union will address the future of the eurozone, including uncertainties over its banking sector, as well as how the United States handles its Fiscal Cliff,1 will weigh heavily on economic balances across all economies worldwide. This seems to be a significant point of inflection on the speed of the rebalancing of economic relevance of AEs in favor of EMEs taking place over the last 12 years. Under this scenario, the ability of EMEs to handle their own fiscal, financial, and real economy weaknesses is critically tied to their ability to weather external shocks and take advantage of growing global savings while searching for yield and growth opportunities. A New Financial Landscape tions in their cost of funding compared to other issuers; (iv) currency manipulation has become a widespread behavior Policies to manage global macrofinancial instabilities are lead- across AEs and EMEs, generally to mitigate currency appreci- ing to, at best, challenge existing assumptions of risk valuation ation (Gagnon 2012), but also to reduce volatility; and (v) and capital allocation. The new global scenario entails a per- central banks’ balance sheets have expanded to unseen levels sistent, stronger presence of governments and/or central in both AEs and EMEs, for different reasons, but with conse- banks in asset pricing. This trend is reflected through several quences on the economy and the financial sector still to be channels, among which the most important are: (i) monetary assessed.2 easing programs of various sorts in AEs are flattening yield While the new scenario is still being defined, market al- curves and bringing long-term yields to historic low levels; (ii) location strategies are guided by bursts of alternate risk-on liquidity regulations are creating a sizeable captive demand and risk-off capital flows. The underlying trend is a “flight-to- for government bonds, implying further drops in yields; (iii) safety� mainly targeting G-4 economies,3 which is creating public sector interventions to support banks either through unprecedented low yields in government debt despite low bailouts and generous liquidity facilities are creating distor- growth prospects and high fiscal imbalances (figure 1). 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 1. Ten-Year Government Bond Yields 6 5 4 percent 3 2 1 0 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 United States United Kingdom Japan Germany Source: Bloomberg. Where Do EMEs Stand? other regions such as Brazil, the Russian Federation, and South Africa. This does not mean that the structural shift rebalancing Vulnerabilities in EMEs cannot be overlooked because EMEs weight in relation to AEs that seemed to be consolidat- they combine external factors and home-grown imbalances. ing after the 2008 crisis is in doubt.4 On the contrary, the The former include volatile capital flows amid depreciating trend is still there, but its pace has slowed down temporarily, currencies, dependency on single exporting products and com- and it is still an open question whether the structural rebal- modities, as well as the potential fatal impact of prices increases ancing favoring EMEs will resume the faster track observed in for soy, corn, and wheat after the drought in the United States, recent years. putting pressure on inflation through food prices, together There are differences between regions depending on with weaker prices for metals affecting growth (figure 3). where each country stands and its exposure to AE’s retrench- Domestic weaknesses include the fact that large EMEs are ing banking sector, direct trade dependency on AEs, or com- at the end of the credit cycle (IMF 2012a), and that physical modity exports. However, some common patterns may be infrastructure is still deficient across all EMEs. Both factors are drawn. constraining EMEs’ growth potential, even in a scenario of fis- On the negative side, expected gross domestic product cal and monetary stimulus. (GDP) growth in EMEs and developing economies for 2012 On the positive side, EMEs have fiscal and monetary and 2013 has been downgraded several times in a row, and is space to take counterbalancing measures, given their lower fis- now expected to be 5.6 and 5.9 percent respectively (IMF cal debt and relative high interest rates when compared to AEs 2012b), well off its postcrisis peak of 7.5 percent in 2010 (fig- (IMF 2012a). Central banks have already been conducting ure 2). China’s GDP growth has also been hit, as shown by the monetary easing by lowering policy rates and reserve require- 7.6 percent figure released for the second quarter of 2012, ments in all regions. The most conspicuous example is Brazil, down from 8.1 percent in the first quarter. This will drag which has lowered its policy rate by 450 basis points in less down most Asian economies and commodity exporters in than a year. Other large EMEs, such as China, In- dia, Indonesia, Turkey, and South Africa have also Figure 2. GDP Growth: EMEs versus AEs eased monetary conditions with the consequence 10 of depreciating currencies. The big question is 8 whether these measures will be as effective as 6 during the 2008 crisis given EMEs’ mentioned 4 structural constraints and stronger economic im- percent balances in AEs. 2 Credit ratings are still holding for all EMEs, 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 but India’s risk of being the first of the BRIC -2 members (Brazil, Russia, India, and China) to -4 lose investment grade status after S&P’s nega- advanced economies emerging economies -6 tive outlook in April is a warning for other Source: IMF 2012b (and July update). EMEs. As global economic conditions get Note: 2012 and after are projections. 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 3. Divergent Commodity Prices ii. Volatility of capital flows to EMEs has increased: equity markets are being more severely impacted, influenced by Commodity Price Index (Dec 31, 2011 = 100) 150 140 risk-on and risk-off behavior, and mirroring the uncer- 130 120 tainty of growth outlooks. Already in the first half of 110 2012, for example, equity markets in EMEs have experi- 100 90 enced large swings in capital flows, starting with a buoy- 80 70 ant period in the first two months, a sharp reversal up to 60 May, and a recovery by the end of June (figure 4). iii. Flows to EMEs’ (sovereign and corporate) bonds have 12 2 12 11 12 12 12 12 01 20 20 20 20 20 20 20 2 been comparatively more stable and concentrated on ne ril ay c ar ly b n De Fe Ja Ju Ap M M Ju aluminum copper corn wheat soybean hard currency: volatility of bond flows has so far been just a fraction of that observed in equity markets, with Source: Bloomberg. 80 percent of EME fixed-income flows in the first half of 2012 directed toward hard currency instruments (JP tougher, there will be a clearer differentiation favoring Morgan 2012). EMEs that are able to continue with structural reforms. Against this backdrop, sovereign and corporate emerg- An Uncertain Scenario for Investment ing market bonds in hard currency—represented by the Allocations and Capital Flows to EMEs EMBIG and CEMBI indices, respectively—have performed consistently well both over a period of one year and year to The changing financial landscape, the enduring crisis in de- date (figure 5). Commodities and EME equity returns have veloped economies, and the downward revisions in global been disappointing and volatile in line with the global growth are setting the tone for investment allocations and downturn. capital flows to EMEs. The prevailing uncertainty of out- comes and duration of these key drivers are having at least Looking forward, volatility in capital flows seems unlike- three major consequences on flows and preferences across ly to dissipate while global uncertainties remain, but whether assets classes: hard currency EME assets will continue to deliver strong per- i. A great share of global liquidity is piling up and sitting on formance is less predictable. Compressed EMBIG and CEM- the fence: flight-to-safety, especially to G-4 sovereign BI spreads, the renewed cycle of easing monetary policies in debt, is undermining potential investments and slowing EMEs, and adjusted levels of exchange rates in several of these the pace of portfolio allocations to emerging market as- economies may make the selection between hard and local sets. currency assets less straightforward. Figure 4. EMEs Inflows and Prices 5 120 4 US$ billions, 4-week average 115 3 Dec 30, 2011 = 100 2 110 1 0 105 1 100 2 3 95 Jan 2012 Feb 2012 March 12 April 2012 May 2012 June 2012 local bond inflows (left scale) equity inflows (left scale) foreign exchange performance (right scale) MSCI EM equity index (right scale) Source: IMF 2012a (July 16). 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Adding to the uncertainty of capital flows to EMEs is a and increased weight of domestic demand in GDP whole suite of regulations to bring under control some of the growth. triggers of the 2008 financial crisis, such as liquidity require- ii. The risk of asset misallocation caused by two factors— ments on banks and insurance companies through higher current distortions leading to too low yields (for exam- government bond holdings and the Volcker rule banning U.S. ple, asset bubbles and misallocated capital), and the ex- banks from proprietary trading. cessive role of the state in capital allocation to counterbalance the downturn. Selecting Policies to Weather the Crisis and iii. The persistence of the downturn in AEs impacting Resume Sustainable Growth EMEs’ growth through the channels of trade, banks, and Gloom for AEs is gloom for EMEs as well. However, there will capital flows. be a great difference between countries when global growth resumes on a more stable basis. The challenge is to work on a Acknowledgment mix of policies that can mitigate the impact of the global crisis The authors would like to thank Olga Akcadag and Ying Ling while better preparing these economies to tap savings from for their excellent research support. This note is based upon AEs when the crisis is over. Prudent macroeconomic policy is the forthcoming “Foreword� in the 2013 Euromoney Emerging a prerequisite for EMEs’ continuous good performance, but it Markets Handbook. The content and design has been adapted does not guarantee success under the current scenario, where for the Economic Premise series. countries are exposed to external shocks beyond their con- About the Authors trol. How each country is able to manage the following three risks will determine its position to take advantage of external Otaviano Canuto is Vice President and Head of the Poverty savings: Reduction and Economic Management (PREM) Network of i. Excessive exposure to the global economy and little room the World Bank. Catiana García-Kilroy is a Senior Securities to maneuver in the persistent downturn (for example, Markets Specialist and Anderson Caputo Silva a Lead Securi- high dependency on trade and commodity exports). The ties Market Specialist, both in the Securities Markets Group challenge is to implement structural reforms leading to of the Financial and Private Sector Development (FPD) Net- fiscal sustainability, broader economic diversification, work of the World Bank. Notes Figure 5. Returns by Asset Class as of August 1, 2012 (%) 1. The U.S. Fiscal Cliff refers to the convergence of the EMBIG 12.1 expiration of tax cuts and automatic spending cuts 12.8 agreed upon in the U.S. Congress, which will be trig- 9.5 U.S. high yield gered at the end of 2012. The U.S. Congressional Bud- 9.4 get Office estimates that they will cut GDP by 4 percent- CEMBI broad 9.5 6.7 age points in 2013. 9.4 2. In the case of AEs, the origin of expanded balance GBI -EM Global Div. -1.1 sheets was the purchase of domestic assets to ease mon- S&P 500 9.4 etary conditions, while in the case of EMEs it was relat- 6.9 ed to funding the accumulation of foreign reserves ei- U.S. high grade 7.6 ther for precautionary reasons or to manage the 10.4 exchange rate. See an interesting analysis of Asia and EM equities 4.1 further references in Filardo and Yetman (2012). -16.9 3. G-4 countries are Germany, Japan, the United King- GBI U.S. (UST) 2.5 7.8 dom, and the United States. Other countries perceived 2.3 as low risk but with lower capital absorption capacity gold -1.2 because of their smaller size, such as Switzerland, Den- 2.3 mark and Sweden, are also being used as safe havens. ELMI+ 3.6 4. As highlighted in Canuto (2010) and Canuto, García- commodities 0.2 Kilroy, and Silva (2011). -10.3 References year to date one year Canuto, O. 2010. “Toward a Switchover of Locomotives in Source: JP Morgan 2012. the Global Economy.� Economic Premise 33, World Bank, 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Washington, DC. http://siteresources.worldbank.org/IN- Gagnon, Joseph E. 2012. “Combating Widespread Currency TPREMNET/Resources/EP33.pdf. Manipulation.� Policy Brief, Peterson Institute for International Canuto, O., C. García-Kilroy, and Anderson Caputo Silva. 2011. Economics, Washington, DC. “Foreword.� In Euromoney Emerging Markets Handbook 2012. IMF (International Monetary Fund). 2012a. Global Financial Stabil- Colchester, UK: Euromoney Yearbooks, www.euromoney- ity Report. April and July, Washington, DC. yearbooks.com/handbooks. ———. 2012b. World Economic Outlook. July, Washington, DC. Filardo, Andrew, and James Yetman. 2012. “The Expansion of JP Morgan. 2012. “Mid-Year 2012 Emerging Markets Outlook.� Central Bank Balance Sheets in Emerging Asia: What Are the Risks?� BIS Quarterly Review June. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise