Neil Shearing on the varied outlook for EMs - Capital Economics
The Chief Economist's Note

EMs even less suited to ‘one-size-fits-all’ approach as pandemic takes toll

Financial markets feed off grand narratives, and nowhere is this more true than in emerging economies. Depending on which narrative you believe, we are either in the early years of an “Asian Century”, in which the world’s centre of economic gravity will shift inexorably towards emerging markets, or EM catch-up will stall as countries fall victim to the inevitability of the middle-income trap. The reality, as we’ve argued before, is far more nuanced. 

Near-term growth prospects vary widely across the emerging world. This is due in part to the different approaches that governments have adopted to handling the pandemic, but also because the pandemic itself has amplified long-standing structural differences between EMs. 

Because of its size, China tends to dominate any discussion about the outlook for emerging markets. Beijing’s “zero-Covid” approach means that the performance of the economy over the next six to 12 months will be shaped to a significant extent by the spread of the virus. Without a shift in approach, new outbreaks will bring new restrictions which in turn will weigh on activity, particularly in the service sector. The problem for forecasters is that there is no way of anticipating when, where or for how long new outbreaks will occur.  

We are on safer ground when it comes to developments in the property sector. While last week’s surge in yields on dollar bonds is not a good measure of the stress facing Chinese developers, the country’s property downturn is nonetheless accelerating. (See Chart 1.)

Chart 1: China Residential Real Estate Activity (million sq. metres, seas. adj.)

Sources: CEIC, Capital Economics

Given that the property sector, and related activities, account for almost one-fifth of China’s economy, this will be a substantial drag on output. What’s more, the property downturn reflects deeper problems at the heart of China’s investment-intensive model of development. The economy is likely to slow by more than most anticipate over the next year – and the legacy will be a permanently weaker path of growth too. This shift will likely be accompanied by renewed bouts of financial stress.  

Strains in China’s property sector and financial system will not on their own threaten stability elsewhere in the emerging world. But a slump in construction activity will hurt commodity producers and have broader market ramifications by reigniting fears of a hard landing. This will hit the usual suspects hardest – commodity producers in Latin America and Africa will suffer a deterioration in their terms of trade, and EMs with large external financing requirements (notably Turkey) would be vulnerable if problems in China triggered a significant dislocation in global capital flows.  

But the problem with viewing the rest of the emerging world through the lens of what’s happening in China is that we miss important domestic developments. The economic prospects for EMs will, of course, be shaped by the external environment, but local factors matter too.  

For policymakers in many parts of the emerging world, inflation is the most pressing current issue. It is now running above target in three-quarters of the EMs that we cover. The good news is that many of the factors that have pushed up inflation this year are likely to be transitory. The rebound in global food and energy prices has had a greater effect on EM inflation since these items account for a larger share of their CPI baskets but, as in advanced economies, the impact should fade in 2022. Likewise, the impulse to inflation from the weakening of currencies during the pandemic will ease.   

But EM central banks are more sensitive to spikes in inflation than developed market central banks, even if the underlying drivers are transitory. Around half of the EM central banks that we cover have already raised interest rates this year (mainly in Latin America and Emerging Europe), and further tightening is likely over the next six months. (See Chart 2.) Inflation should drop back in most EMs over the second half of next year, but in Central and Eastern Europe excess demand is leading to a more fundamental build-up in core inflation. Policymakers in the region are likely to raise interest rates by more than the consensus currently expects

Chart 2: CE EM Interest Rate Diffusion Index (No. of Central Banks Raising Rates Less No. Cutting Rates) 

Sources: Refinitiv, Capital Economics

At the same time, fiscal pressures are also building in a number of emerging economies, particularly in Latin America. These are not the fiscal concerns of the past, in which EM governments borrowed in foreign currencies and then found themselves shut out of external funding markets and/or facing extreme balance sheet strains as domestic currencies weakened. Today, such risks are confined to a handful of relatively small economies such as Sri LankaEthiopia and Tunisia.  

Instead, most EM governments now borrow overwhelmingly in local currencies, and sovereign bond markets are therefore backed by national central banks. But while this reduces funding risks and currency mismatches, the pandemic has nonetheless caused budget deficits to widen and public debt burdens to increase. In many countries, fiscal positions were already looking shaky before the pandemic. Now they are altogether worse. This is particularly true of Brazil and South Africa. A multi-year fiscal squeeze will be needed to restore fiscal stability in these countries, although that looks politically unpalatable. 

Finally, it’s worth noting that these inflation and fiscal concerns do not generally apply to EMs in Asia. Inflation in the region is low, helped in part by price subsidies and the make-up of CPI baskets, and fiscal positions are stable. Instead, the key challenge facing Asian policymakers remains the pandemic – or rather their approach to managing it.  

While economies in Asia have not fully adopted China’s “zero-Covid” approach, they have taken a much tougher stance than governments in other parts of the world. Accordingly, while export industries are running at full capacity to meet the surge in global goods demand, domestic-facing sectors are lagging and, without a shift in approach, recoveries will remain vulnerable to new waves of the virus.  

The result is a complicated picture, with different forces determining growth prospects and policy decisions in different parts of the emerging world. To the extent there is a common thread, however, it is that recoveries are likely to slow by more than most anticipate next year. In that sense, the prevailing narrative about the near-term outlook for emerging economies looks too optimistic.

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