Although the US is still the world's largest economy, accounting for 20% of global GDP on a PPP basis compared with 15% for China, which is number two, China is growing 11% this year, compared with 2% for the US and 9% growth for India. At least on a PPP basis, the US is still the largest locomotive, but India and China are supplying most of the power.
High commodity prices are helping many developing countries. Although emerging Asia is still a net importer of commodities, both Latin America and Africa are major exporters. These regions have been aided by strong commodity prices. Higher commodity prices are, in fact, pretty much a zero-sum game for the world economy, because they help the producers but hurt the consumers, at least when they are propelled by demand increases rather than supply disruptions.
Key risks to our baseline economic forecast include a prolonged recession in the US or a disorderly correction in international trade imbalances and capital flows (see Table 1). A significant disruption of oil supplies could also damage the world economy.
Surviving Financial Market Turmoil
Although emerging markets spreads have widened somewhat as a result of the turmoil in the US credit market, private bonds have had much less of an effect on them, in large part because of limited exposure to securitized assets. Improvements in macroeconomic performance and financial markets have made emerging marketsùparticularly the high growth, larger and more stable BRIC countries (Brazil, Russia, India, and China)ùa magnet for capital inflows. These key points are evident:
The Federal Reserve's 50 basis points (bps) cut in the fed funds rate has moderated the flight from riskier asset classes, and credit spreads have pulled back. However, securitized-asset markets remain stressed. As investors reassess risk, emerging markets should benefit from their limited holdings of subprime debt.
Even allowing for negative trade effects from the US slowdown, GDP in emerging markets should continue to rise more than 7% per year because of healthy domestic demand conditions and export strength to non-US markets. The fact that the US slowdown is concentrated in housing, which has a relatively low import content, helps. (See "Emerging Markets Credit Quality: Tackling Volatility From A Position Of Strength," published Oct. 3, 2007, on RatingsDirect.)
Emerging markets are better equipped to handle credit restraint because of their fiscal and current account surpluses. Foreign currency reserves have increased. Better external debt management policies, including a lengthening of maturity schedules and low exposure to subprime debt, also are helping to attract risk-averse investors.
Emerging economy equities have been performing extremely well, with all regions outpacing the developed markets. Currently, Latin America is the best equity market performer, with a 70% gain during the past 12 months, followed by Asia-Pacific (excluding Japan) with a 40% gain.
Further, financial shocks can move to emerging markets swiftly through financial flows and more gradually through trade effects. The initial flight to safety pushed credit spreads higher for both private borrowers and emerging market sovereign borrowers, with liquidity drying up even for creditworthy borrowers. Even so, investors have been more relaxed concerning emerging markets; credit default swaps (CDS) spreads have pulled back dramatically (see Chart 1) from their August panic, with emerging markets running just 30bps above pre-crisis levels. The quick return to normality for emerging markets is encouraging, suggesting some degree of "decoupling" from the US credit cycle.
However, risks remain. Recently, banks in Europe have also been forced to write down leveraged-loan commitments because of their inability to resell them, which could in turn force liquidation of more marketable securities, including an exit from emerging markets. The weakest borrowers could become a source of systemic risk in the international financial system.Global Imbalances Are Still Dangerous
Today, emerging markets show far less vulnerability to credit markets than during previous crises because of the steady inflow of capital flowsùattracted by high growth along with improved corporate governance standards. Capital is now flowing from the emerging economies to the low-saving developed economies, especially the US The economic and financial power of the Asian region has risen. The Asian bloc accounts for a third of the world economy (PPP basis) and half of the world's monetary reserves.
Emerging market imbalances have eased. Most governments have brought their fiscal deficits under control, showing a small net surplus last year. Trade accounts are positive. The surpluses allow the emerging economies more independence from the global financial market, but markets remain tightly linked.
The trade surpluses have allowed emerging markets to build up $3.2 trillion in foreign exchange reserves ($2.1 trillion excluding China), which provides a strong buffer against any credit market disruptions. More pertinently, short-term debt relative to the level of external reserves has dropped considerably, blunting the impact of any funding deficits. Reduced reliance on external debt has accompanied improved debt management. Except for emerging Europe, external debt as a percentage of GDP has fallen. Rollover risk exists for emerging markets next year, with about $290 billion in private bonds and loans coming due. Russia takes up the lion's share at $89 billion, but its foreign exchange reserves are sizeable at $480 billion.
But the enormous international imbalances could still cause problems for the emerging and developed markets. Investment inflows from abroad have so far balanced out the US's formidable external deficit. However, the narrowing of interest-rate spreads with Europe is beginning to push the dollar downward again and may require higher US interest rates. Because many of the emerging economies tie their currencies to the dollar, the resulting drop in their exchange rates threatens to restart inflation and raise interest rates. On the positive side, a lower exchange rate would help the competitiveness of their exports (but remember that commodity prices are set in world markets).
The "yen carry trade" has been a big part of the financing of the US trade deficit. Japanese investors or overseas investors borrowing in yen have been investing in dollar assets. Investors are getting nervous, because a declining dollar will offset the interest-rate spread between the US and Japan, making these deals unprofitable. In addition, investors have been stung by the decline in value of private bonds, especially mortgage-backed securities and collateralized debt obligations. A stoppage of this flowùor worse, a reversalùcould cause a disorderly decline in the dollar and a sharp jump in US bond yields, regardless of any Fed action.
These investors have also pushed into emerging markets securities, in part because of the linkage of the currencies to the dollar. If this trade shuts down, it could hurt emerging market yields as well. We believe this disorderly scenario is unlikely, to some extent because we don't believe that the Bank of Japan would permit the yen to strengthen sharply against the dollar. Yet, eventually this carry trade has to contract.High Commodity Prices Help Many Emerging Economies
Strong global growth has elevated demand for virtually all commodity groups, increasing revenues for commodity exporters. The Middle East has benefited from higher oil prices, while Africa and Latin America have profited from strong metals and agricultural prices. Continued rapid growth in China and India is likely to keep commodity prices firm, despite the US slowdown.
The higher commodity prices have been the major force behind the swing of trade balances into surplus. Although Asia and Eastern Europe have strong manufacturing sectors, minerals and agriculture are still the major exports for the Middle East, Africa, Latin America, and Russia. The dependence on commodities is a strength right now but could become a problem if commodity prices drop.
A recession in the US and other developed economies remains a threat to emerging economies. The trade share of GDP is high for the Middle East, Asia, and emerging Europe. While Latin America has lower export and import shares, exports continue to be a major engine of growth. The US remains the largest customer, but exports to Europe and emerging markets are growing significantly. On balance, Asian trade shares are about evenly split between the US and the European Community (about 17% each). Asia shows less susceptibility to a US slowdown, with a substantial increase in intra-regional trade. Latin America has the highest sensitivity.
Regional Strengths And Risks
The revival of the Russian economy has helped to pace Eastern Europe, as high oil prices boost export revenues, and energy-related investment keeps capital inflows strong. With domestic investment rising, Russia should be able to maintain a 6.5%-7.0% growth rate. However, inflation risk is high, while energy sector dependence poses added risk if oil prices fall.
In Asia, strong infrastructure investment and consumer demand have pulled the Indian economy up, and growth is on a solid trajectory, increasing investor appetite for Indian investments. The IMF reports that risk capital held for sectors, such as real estate, has been raised above Basel norms by financial institutions, providing a safety net for the banking system. Corporate governance standards have improved. China remains the world's fastest-growing major economy because of investment spending and export growth. However, excessive export dependence on the US will prove troublesome, and the trade surplus is too large to be sustainable. Eventually, China will have to shift to an economy led by domestic demand rather than exports.
Latin America as a whole remains the most dependent on short-term capital inflows, making it more susceptible to sudden shifts in international portfolio adjustments. However, Brazil has made substantial strides in strengthening the banking sector, and the well-supervised financial system has increased investor confidence. So far, inflation, the usual bane of Latin American economies, has remained under control. Strong commodity prices have shifted Latin America into surplus, rather than its usual deficits.
Africa is growing almost entirely on the back of strong commodity prices and consequent export revenues and investment flows into mining and related sectors. Inflation remains a problem, however, and except for South Africa, the fundamental infrastructure needed for development remains weak. Commodity prices can carry the African economies, but if they drop, growth is likely to slow sharply.
The emerging markets are now driving world growth, a turnaround from recent decades. So far, the positive surprises, especially from China and India, have offset the negative surprises from the US World growth remains strong, despite the weakness seen in the US economy.
But the recent financial turmoil could change that picture. So far, the emerging markets have been relatively unaffected by the problems. We expect that most Asian and Middle East economies will remain immune, because they are exporters of capital rather than importers. However, the Latin American and African economies are less insulated and may still have problems. These would worsen if commodity prices drop back from current highs.
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