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27 Feb 2014

Emerging markets: contagion and immunity

Stephen King

by Stephen King

HSBC Group Chief Economist

Emerging markets: contagion and immunity

Productivity gains have been lacklustre and interest rates are already low in the developed world

Although the countries affected by recent emerging-market upheavals have their idiosyncratic problems, they face common challenges: disappointing growth, deteriorating competitiveness, declining commodity prices and dismal balance of payments positions.

In the past, the US acted as a “consumer of last resort”, its rapidly expanding current-account deficit providing support to exporters elsewhere. But since the financial crisis it is no longer willing or able to perform that role and potential replacements are in short supply. Neither China nor Japan is likely to grow fast enough this year to pick up the baton.

Our current forecasts suggest only modest adjustments in current-account deficits within the emerging world. But history suggests the adjustments may end up a lot bigger. Domestic demand may eventually suffer much more, held back by higher interest rates, weaker currencies and, where elections allow, tighter fiscal policy.

Our current forecasts suggest only modest adjustments in current-account deficits within the emerging world

From a trade perspective, the major developed-world countries most heavily exposed to the emerging-market upheavals are Germany, Italy and Spain. Japan is the least exposed. But similar calculations made during the late-1990s Asian Crisis proved hopelessly wide of the mark.

Back then, the developed world easily decoupled from the economic traumas elsewhere. Today, such decoupling seems less likely. There is no obvious “new economy” driver: developed-world capital spending is weak, productivity gains have been lacklustre and interest rates are already low.

True, the US Fed and other central banks could eventually resort to more quantitative easing, but the lesson from the late-1990s is that monetary stimulus might be on offer only if financial conditions become extreme. It was only because of the collapse of Long-Term Capital Management, the US hedge fund manager, that the Fed eventually cut interest rates in 1998 – more than a year after the onset of the Asian Crisis.

In hindsight, five key ingredients enabled the Western world to decouple from the Asian fallout, none of which were fully recognised at the time: falling commodity prices, surging productivity, low inflation, monetary stimulus and rampant asset prices. But it all proved too good to be true. Stock prices eventually tumbled, commodity prices rebounded, companies were forced to deleverage and the US economy went into mild recession in 2001.

The late 1990s showed that the developed world can decouple – temporarily, at least – from nasty upheavals in the emerging world. Yet the conditions in place then are not universally in place today. Commodity prices have certainly fallen but productivity growth is poor. Inflation has come down but economic growth has persistently disappointed. Asset prices have been rampant but interest rates, already at zero, can’t be cut further. And, as noted earlier, the US is no longer the consumer of last resort: its balance of payments position has been remarkably stable.

That doesn’t mean the developed world is about to be dragged down by problems within emerging-market countries. The late-1990s experience is encouraging to the extent that it shows that shocks in one part of the world don’t always have wholly negative effects elsewhere. However, that experience was both exceptional and, ultimately, unsustainable. In a post-financial crisis environment, it is unlikely to be repeated.

We are not radically changing our developed-world forecasts currently, but persistently sluggish growth in these countries alongside the threat of crunching current-account adjustments in the emerging world, points to persistently low inflationary pressures. So 2014 may be another year in which inflation undershoots targets.

This research was first published on 18 February 2014.
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