EM reversal

October 9, 2015

Lima, Peru, is the capital of the financial world for the next few days, as finance ministers, central bank governors and private-sector financial types gather there to attend the annual meetings of the IMF and World Bank. This year, in sharp contrast to the last five, the mood is unhappy — even grim.


The main reason is that it is patently impossible to continuing spinning the story of recovery from the Great Recession of 2008/09, for the simple reason that no-one believes it any more. The massive effort to pump money into the global economy as a means of promoting sustainable growth has failed, the short-term gains generated by this strategy are fading out, leaving behind unresolved long-term problems now aggravated by the addition of ever more debt.


But the immediate cause of the gloom is much more tangible than mere failed policy ideas. It is the dramatic change of fortune that has swept over much of the poorer part of the world — those countries nowadays designated “emerging” and their financial markets “emerging markets”, or EM for short.


From a long-term perspective, and despite periodic crises along the way, the world has lived through a generation or more in which global growth was driven by the emerging economies, of which China was by far the most important — but by no means the only player. Indeed, as discussed here over the last year, China’s phenomenal growth has been the driving force behind other major growth stories experienced by countries around the world, from Australia to Russia to Brazil.


China heading downhill


The bad news is that the China growth story is now over, that China’s rate of growth has fallen sharply, is still falling and might yet fall much further. Even if it does not, all the countries that had waxed fat by feeding China raw materials are now in bad shape.


As a direct consequence of this change in the global economic climate, the direction of money flows in the global financial system has reversed. Whereas over the years and decades of rapid EM growth, capital flowed from the developed markets (DM) to the emerging ones, attracted by the greater potential and higher yields offered by the latter, it now appears that a fundamental reversal has occurred.


Capital is pouring out of the EM world and heading to the DM one. The process is being tracked with alarm by everyone in the global markets, but perhaps the most ‘official’ such player is the Institute of International Finance (IIF), itself a part of the IMF/ World bank complex. In its latest report on capital flows, published on October 1, ahead of the IMF/ World Bank meetings, the IIF notes that “Capital flows to emerging markets have weakened sharply in recent months.” That, however, is not news — everyone knew that. Furthermore, given the trends of recent months, the IIF’s forecast that “We project 2015 non-resident capital inflows to fall below 2008 levels” is bad news, but not shocking. However, what follows is sensational:  “With resident capital outflows rising, net capital flows to EMs in 2015 are forecast to be negative for the first time since 1988.”


Let’s explain that sentence. There are two components in capital flows into or out of any country — those of foreigners and those of residents. When foreigners invest in a country they create an inflow and when residents (individuals, companies, financial institutions and the government or central bank) invest in other countries they create an outflow. However, foreigners can also liquidate and repatriate existing investments, generating an outflow, and residents can do the same with their overseas investments, causing an inflow. In the normal course of affairs all of these things occur, with the net result reflecting their cumulative and offsetting totals.


Who is most vulnerable?


What the IIF is saying is that this year, for the first time in 27 years — basically, since the China-led EM revolution in the global economy took off — the net result will be an outflow of capital from EM. Furthermore, the IIF says that the key component of this net outflow will not be foreigners liquidating their investments — although that is certainly happening — or even the dearth of new foreign investment, which is also occurring (“non-resident capital inflows to fall below 2008 levels”). Rather, the key is “resident capital outflows rising”, which in plain language means that the monied class in the EM world, especially China, is sending its money overseas.


For countries that rely on foreign capital to cover their trade deficits or to finance their growth-generating investments, the drying-up of the flow of foreign capital is disastrous. If it is accompanied by domestic capital flight, it is doubly so — and this is what is happening in China on a very large scale.


But China at least has deep reserves and runs a hefty trade surplus, while it is also taking measures to stem the flow. According to the IIF analysis, those EM countries most vulnerable to a credit crunch are the ones weighed down by “current account deficits, questionable macro policy frameworks, large corporate FX liabilities, and acute political uncertainties. Brazil and Turkey combine these features.”


Erdogan, in short, is toast — although don’t expect him to go quietly. Israel, fortunately, does not suffer from the problems listed (although most Israelis are unaware of that). Just as well, because the ride is going to be very scary.

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