Last updated 27/6/2019
Emerging Markets on the Rise
Over the past several decades, markets outside the major advanced economies have become increasingly important drivers of global growth and are increasingly integrated into the global financial system. As such, the significance of these markets for both international investors and those analysing global economic developments has risen. Though a strict definition of emerging markets has never existed, countries associated with the term are generally characterized by strong growth, strong inflows of FDI, a high degree of openness to external markets, and openness to reforms that strengthen political and financial institutions.
Halfway through 2019 it appears the waters have calmed for most emerging markets after a trying and turbulent 2018. As Figure 1 shows, many of the emerging market currencies that were hit particularly hard last year are so far unchanged or have even appreciated against the US dollar this year (the Argentine Peso and Turkish Lira are unsurprising exceptions to this).
Figure 1 - Emerging market currencies vs USD (% change)
In many ways this shift for emerging markets makes sense. Recall that early last year the Federal Reserve’s tightening cycle was in full swing and markets were anticipating significant further interest rate hikes from the US central bank. The ECB as well was preparing to end its Asset Purchase Program by the end of 2018 and pave the way for interest rate normalisation. Though the former has come to pass, the latter has been put on indefinite hold. Instead of readying for rate hikes, ECB officials are now discussing the possible need for additional stimulus. Likewise, the Fed has taken a 180-degree dovish turn since this time last year, and markets (as of 26/6/2019) are pricing in multiple rate cuts this year.
For emerging markets, the turning tide can be a double-edged sword. Easier global financial conditions thanks to looser policy from the Fed and ECB usually translates into less turbulence for emerging markets. With lower interest rates in advanced economies, emerging markets tend to have easier access to financing and benefit from increased capital inflows. Even economies with sizable imbalances may be able to secure relatively cheap financing in a low-interest-rate/search-for-yield environment. Table 1 compares many of the imbalances that could lead to financing problems in more difficult economic environments with exchange rate performances thus far in 2019. Though India and Brazil stand out in a negative way in terms of their public finances, both countries’ currencies are roughly unchanged versus the US dollar since the beginning of the year. Investor risk aversion doesn’t simply fly out the window when global interest rates fall, however. The structural problems in Turkey and Argentina, for example, are clearly still weighing on those countries’ currencies.
Table 1: Emerging market vulnerabilities heatmap
But the shift in outlook for global central bank policies cannot be interpreted as all good news for emerging markets. Indeed, the reason why these central banks have shifted policy expectations is because going forward global growth is expected to slow. In part this is simply a cyclical slowdown that tends to follow the peak of a business cycle, particularly in the US. However, ongoing risks and uncertainties, such as Brexit and the escalation of the US-China trade war and other trade conflicts between the US and its trading partners, are weighing on the growth outlook as well. Growth slowdowns in the US, EU and China, and increased trade conflicts globally, will in turn hurt emerging markets, many of which rely on trade for a significant portion of their economic growth.
The economic slowdown in China is also feeding into global growth concerns. China’s growth deceleration picked up in 2018, raising fears once again of a hard landing in the second largest economy in the world. Part of the slowdown over 2018 can be attributed to the authorities’ deleveraging efforts and efforts to reign in the shadow banking sector, which led to a decline in credit growth and infrastructure investment. Escalation of the trade war with the US also weighed on business sentiment and China’s foreign trade. In response, the authorities switched gears from focusing on credit imbalances to providing stimulus for the economy through both monetary and fiscal policy measures. While the authorities do have the means and the will to avoid any substantial adverse growth or employment developments, they are facing a tradeoff between promoting growth through stimulus and addressing still outstanding imbalances and needed reforms. As such, risks still remain and growth will continue to moderate. As China becomes a more financially open economy, the risk of spillovers from China to the rest of the global economy will increase.