Märten Ross. Emerging Market Resilience: Transitory or Permanent? The (Mainly) Baltic perspective

Bretton Woods II Under Stress, 18 April 2008, Madrid

Slides to the presentation (pdf)

Emerging Market Resilience: Transitory or Permanent?
The (Mainly) Baltic Perspective

Märten Ross
Madrid, 2008

It has been famously said that happy families are all alike, but that every unhappy family is unhappy in its own way. This also appears to be the case in the world of economy and finance. Only about ten years ago, the so-called Asian and LTCM crises hit the globe and kept emotions high. At that time, the strength of the USA's economy was believed to be one of the crucial factors as to why the crises turned out to be relatively short-term events in the so-called emerging economies.

Today things seem to be turned upside down - or, indeed on their heads. Developed financial markets are in the midst of turmoil and as a corollary of the theory of de-coupling, it is being seriously argued that these same emerging economies (EMEs) could maybe feel safe from these unpleasant developments. In addition, some have argued that EMEs could be expected to pull the USA out of its recession, to keep European recovery on track and, indeed, provide liquidity and capital to countries where nominal per capita incomes are ten times higher.

Is this previously unheard of scenario to materialize? In the following, I will first elaborate on the framework and then touch upon different possible transmission channels to evaluate how likely this positive outcome actually is. As an aside, I should stress that my point of view is unavoidably biased to represent the experience of a very small EU member country and any wider conclusions need to be taken with that view in mind.

What are we looking for?

My general understanding is that there are good reasons to be optimistic about the ability of many emerging economies to withstand financial sector turbulence and the probable resulting slowdown in economic activity. This optimism derives from the knowledge that much of the strength in growth and trade over recent years has been accompanied by improved economic policies in many parts of the world. No one should understate the importance of these efforts.

However, we should still be realistic about the kind of outcome we are looking for. If there are no spillovers from the world's financial markets and trade flows to the economic activity in emerging economies, then the logical question arises as to whether we were too enthusiastic about the extent of integration in the first place. We just can't expect integration to only be a one-way bet in the upside phase that loses its influence during a slowdown.

It should also be stressed that the strongest underlying factor why we believe economic growth continues in many lesser-developed countries is the belief that convergence and income catch-up policies are correct. However, here it is often forgotten that convergence is an unavoidably relative concept; i.e., the concept of relative growth, not absolute growth levels. Therefore, if growth in converging countries slows down markedly, it is not yet proof of "non-resilience" if such growth declines in EMEs, but differences remain broadly in place.

Consequently, for a start, I would expect emerging economies to withstand the present global shocks reasonably well and this could be manifested in the continuation of reasonable growth levels. However, at the same time it would be a mistake for developed countries to have the same growth levels as emerging economies in their calculations as a baseline scenario as they did a year or two ago.

In the following, I will touch briefly upon my present experience with all the major channels of potential spillovers: the financial sector, external demand and, additionally, price channels.

The financial channel

The influence of the financial channel has been quite rapid in the Baltic countries. It is in no way a surprise if one takes into account the extent of their integration in the financial markets of Europe. The major contributor to the fast spillover is the private sector lending channel, where most of the financing has been done in euros and is based on the European inter-bank lending rates. Clearly, the recent turmoil has a direct and automatic impact on these companies and households, as the spreads between inter-bank lending and risk-free swap rates have increased. However, this is not a particular Emerging Europe-specific phenomenon. As the increasing economic weakness has kept a lid on policy rates, the overall conditions of financing have remained quite close to the historic average in Europe in general and in the new member states in particular.

The same could be broadly said about other financial markets. There has been a clear downward correction in stock prices as well as real estate prices, but the same could be said of many (or even most) other European markets. Therefore, the financial sector has been resilient to idiosyncratic shocks but non-resilient to global trends.

It is true that the Baltic countries have been seeing bigger corrections over the last year or so in the prices of financial markets, but one should be clear here that the correction had already started before the global turbulences. It was and indeed still is related primarily to the needs for internal stabilization. If we compare our developments since the global turbulence began, then the trends have not been particularly different in the overall picture of things.

Even the much voiced concern that countries with large current account deficits will experience an extra shock from global developments has not fully materialized, though there is some indication that financial flows have recently slowed down more in countries with higher initial current account deficits. However, these calculations tend to show a rather marginal difference; in particular, if one takes into account the unavoidable adjustment needs of large deficit countries with or without global financial turbulences in the first place. Furthermore, looking from within these countries one has the feeling that there is no 'credit crunch' at all. Therefore, broadly speaking, we have seen a strong correlation of financial developments, but relatively good resilience overall and no extra shock in emerging new member states.

One possible explanation here could be that what actually matters in these circumstances are not macro variables as such, but concrete financing patterns and financial institutions that are active in one market or another.

Indeed, if more than half of external financing is actually intra-group bank financing of 4 to 5 regional banking groups, then it definitely matters whether these specific institutions are part of the financial turbulence or not. Not surprisingly in this case, the current account deficit in country X could possibly show no divergence from the already established trend if these institutions themselves are well financed and soundly capitalized, as is the case in the Nordic-Baltic regions. However, if there happens to be even 1 or 2 banks that were strongly exposed to bad assets in the sub-prime market or whose financing was heavily reliant on shakier parts of financial markets, no current account surplus can act as an immediate shock absorber. The relevant case studies can be found in 2007 if we check which banking systems' liquidity or stability was influenced by sub-prime turbulences and compare it to the current account positions at the time.

This leads to the initial conclusion "from the field" that while the financial sector channel has been quick to influence emerging economies, these economies have shown a fair amount of resilience to additional asymmetric shocks. If this could be related to better fundamentals in the setup of financial intermediation, it could be a sign of permanent resilience to the global slowdown.

The trade channel

Regarding the trade channel, there still is, in many respects, a very limited influence on the Baltic countries. Export growth was robust throughout 2007 and remains so in 2008.

This is not particularly surprising when one takes into account the fact that our prime export markets are still doing reasonably well and pessimism is still primarily about future outlooks. In addition, it is not of minor importance that even we, who are not oil producers, can also be the partial beneficiaries of global imbalances as higher global food prices have been an overall positive factor in our trade account due to the strength of our agricultural sector.

However, the recent economic forecast growth outlooks of our central banks have been downsized for both 2009 and 2010, which is in line with the expected decline in activity in our main export markets. This is partly technical and relies fully on the external forecasts of international institutions and the historical experience of these developments on our export ability.

However, this is also partly intuitive and is supported by recent anecdotal evidence. For example, how the weaker dollar has resulted in tougher competition even in the food markets in Europe from US producers; or how weaker demand from the US has been pushing the producers with high exposure in that market (e.g., from China) to look for alternatives and thereby deteriorate the market conditions for our exporters as well, even in other markets.

Being a small and open economy, these things are definitely never one-sided and only negative. For example, if lower world growth puts pressure on commodity prices, then we can clearly benefit rather quickly from lower input costs in order to maintain our competitiveness.

However, while we expect our exporters to be able to withstand the worst of the global slowdown, it would be clearly too complacent of us to underestimate its negative outcomes at large. This will also definitely influence our general growth prospects, including domestic demand.

The price channel

So far, the strongest spillover has, maybe surprisingly, been evident in inflation developments. While there are probably no direct links between inflation and financial turmoil, one should not forget that both most likely have similar roots and therefore can not be separated in analysis.

A recent IMF forecast saw global inflation increasing from about 3.5% in 2007 to approximately 4.7% in 2008. In addition, while the recent highs of other commodity prices are unpleasant, once food prices follow this trend things will turn much more dramatic.

Here, it is worthwhile to step back and ask, 'What is the cause of the recent turmoil in financial markets?' Naturally, there is no single answer to that question. Since it can be argued that the relatively loose overall global liquidity situation over most of this century was one reason for the excessively low risk premium across the wide spectrum of instruments and maturities, then it is strange to forget its potential influence on global price levels.

Things were not that bad in the beginning as the credibility of monetary policy remained very strong and core inflation remained well in check in the big economies. However, as of today the cumulative difference between core and headline inflation has reached levels where one can not ignore the fact that the reversal of relative prices will either be very painful or not happen at all, meaning that we have to admit that recently global inflation has been high.

In practice, this means that emerging economies are hit by unexpected spikes in food prices. However, while mature economies feel the same pressures, it appears that due to different exposures of mature and emerging economies (e.g., to food prices), this part of the shock of global imbalances might hurt the latter more than average.

It is also important that contrary to the situation of a few years ago it is much more difficult to persuade the public of the likely temporary nature of these shocks. This has put pressure on consumer confidence and we have downgraded domestic demand prospects in our forecasts as a result. However, some monetary policy credibility might have also been lost, but hopefully only temporarily.

Conclusion

As of today, we have good reasons to believe that emerging economies have a good chance of reasonably withstanding the aftermath of the sub-prime induced financial crisis and, more generally, the stress of the unwinding of global imbalances. However, it would be too complacent of us to assume that their influences will be negligible.

Märten Ross. Emerging Market Resilience: Transitory or Permanent? The (Mainly) Baltic perspective