Article12 Aug 2013

Emerging Markets: This Time It’s Fiscal

Citi GPS Opinion Article
The slowdown in emerging markets (EM) is now so well-flagged that it’s reached the front cover of The Economist. Certainly, EM growth is weak and apparently getting weaker. Citi expects EM GDP growth this year of 4.7%; quite a bit lower than our 5.3% forecast of six months ago, and a far cry from the pre-Lehman days where EM growth ran above 8%. The clearest way to understand the slowdown is to think of it as two external shocks.

First, emerging economies’ exports have been hit hard by the collapse of import growth in the G10*. And second, the slowdown in China – which has roots of its own – has produced all sorts of knock-on effects throughout the emerging world: both as a group of economies, and as an asset class, emerging markets are exceptionally China-dependent, given the nature of the economic integration process in Asia, and the steady creation, over the past 10 years, of a ‘China-commodities complex’.
If you’re a policymaker faced with a big shock to your country’s export growth, naturally you’ll try to do what you can to support the domestic components of GDP: private and public sector spending. To achieve this, the two most natural paths to take are i) to boost private sector credit extension, and ii) to loosen fiscal policy.

How to grow when external demand is weak?

Attempts to boost private sector credit extension in EM have been hobbled by a number of factors. There are a quite a few countries — Korea, for example, or Brazil or Malaysia — that have already had substantial credit booms, and so these economies are now saddled with a stock of private sector debt that is quite high given their income levels. And there is another group of countries — Russia, Turkey, South Africa, for example — where credit growth has recently been pretty high, but is somehow failing to translate into more rapid rates of GDP growth. Russian GDP growth, for example, will likely struggle to exceed 2% this year in spite of the fact that private sector credit growth has exceeded 20% in the past few quarters.

Most worrying perhaps is China, which falls into both camps: the stock of credit is very large indeed given China’s income level; and even the exceptionally strong rates of credit growth in recent quarters have failed to boost GDP growth. On the contrary: the challenge facing China nowadays is whether the People’s Bank of China’s (PBOC) effort to throw out the ‘bathwater’ of excessively speculative financial sector activity can be achieved without damaging the ‘baby’ of real-economy credit on which Chinese growth so crucially, if inefficiently, depends.

If the scope for credit growth is low, looser fiscal policy might be an answer

So, if private sector credit extension is, for various reasons, a lousy tool for emerging economies to boost growth, another solution might be looser fiscal policy. Here, at least, the starting point is pretty robust. Public sector balance sheets in the emerging economies are generally strong, and the 2000s saw a big improvement in their fiscal credibility with the aggregate public debt/GDP ratio for EM falling from 52% in 2002 to around 42% last year. And it’s not only that the debt burden fell: the average maturity of government debt increased and the currency composition of public debt improved, reducing countries’ exposure to exchange rate risk. Since the mid-2000s, this improvement was rewarded by the rating agencies through a steady rise in their assessment of sovereign creditworthiness.

Although generally strong, to some extent fiscal positions have already deteriorated since the Lehman crisis – the EM public debt/GDP ratio had fallen to 37% in 2007 before rising in recent years. This is fair enough: it is absolutely defensible for governments to have used automatic stabilisers in public finances during the Lehman aftermath. But there are signs that some budget discipline is being lost. During the period 2003-2008, non-interest public spending across EM was stable at 23% of GDP. Now, primary spending in EM has risen to 27% of GDP. There is more going on here than can simply be attributed to automatic stabilisers.

And there is very likely to be more fiscal deterioration in EM, as more policymakers wake up to the idea that strong-ish public balance sheets give them ‘fiscal space’ to support growth, particularly at a time when private and external demand conditions are unexciting. And there are two more reasons in particular why public sector balance sheets are likely to weaken. The first has to do with a growing enthusiasm in EM for spending on infrastructure. The second has to do with the electoral cycle. This combination of factors leads to the conclusion that the best days of EM creditworthiness are probably behind us.

Infrastructure will help shape plans for fiscal loosening

Throughout EM, one area that’s receiving increasing attention is the infrastructure deficit that exists in so many countries, and especially in some of the largest: Brazil, India, Indonesia, Turkey, South Africa and Russia. There seems to be empirical evidence that infrastructure development can boost growth: investment in telecoms, roads and electricity networks is reckoned to be particularly enabling of economic activity. And even if the empirical evidence isn’t straightforward, the logic of investing in infrastructure appears watertight to many policymakers: improving a country’s physical infrastructure ought to enhance productivity, and increase capital formation by reducing transaction costs. And there is often thought to be a social case for infrastructure, i.e., better roads get people more easily to things like schools and hospitals.

The instinct that infrastructure is a ‘good thing’ is receiving a boost these days from the idea that there is a ‘super-Keynesian’ benefit from this kind of public spending. Indeed, a World Bank Working Paper published by its former chief economist last year was titled: ‘Beyond Keynesianism: Global Infrastructure Investments in Times of Crisis’. The argument is that public expenditure on infrastructure can be bottleneck-releasing and, in the end, self-financing. But frankly it’s not easy to draw a firm conclusion about causation. Just as infrastructure might ‘cause’ growth, growth also ‘causes’ infrastructure as, after all, demand for infrastructure is a function of income.

Looking around emerging markets, publicly-funded infrastructure ambitions seem high almost everywhere. President Putin has pledged to spend half of Russia’s $85 billion National Wealth Fund on infrastructure projects in the long run. The Development Bank of South Africa is being recapitalised in a push to expand its role in infrastructure lending. In Indonesia — where the cost of a container shipment from Padang to Jakarta is some three times the cost of the same container getting from Jakarta to Singapore, an almost identical distance — the government’s infrastructure development strategy document claims ‘Indonesia can afford to spend more on infrastructure development…because its fiscal and debt position is strong’. The Turkish government is aiming for an ambitious upgrade of Istanbul’s airport, a canal through the city, new highways, and other projects. Other examples abound.

The model for aggressive infrastructure development in EM is, of course, China, whose infrastructure spending has dwarfed that of other EM’s and has risen in recent years: infrastructure spending was 12% GDP in 2004, and rose to over 17% GDP by 2010. But China’s experience shows i) how massive infrastructure investment can coincide with falling, not rising growth; and ii) how public — or quasi-public — balance sheets end up bearing a good deal of the burden of this spending. The standard model for infrastructure development in China during recent years has relied heavily on an increasing debt burden for local governments and state-owned enterprises. Rising contingent liabilities for the public sector are likely to be a feature of the push towards EM infrastructure. Brazil’s current push to improve ports, roads, railways and airports, for example, will require very heavy use of public sector guarantees. Contingent liabilities are a big issue in Malaysia too. While the published public debt burden is 53% of GDP, publicly-guaranteed bonds issued by the Non-Financial Public Enterprises under the Economic Transformation Programme probably add another 15 percentage points to that number.

Infrastructure spending might not produce growth, but liabilities are sure to increase

Spending public funds on infrastructure will increasingly feel like a good idea to policymakers in emerging economies. This of course is no bad thing. But there is no automatic growth response to expenditure on infrastructure, and it will likely entail further erosion of the ‘balance sheet strength’ that used to be a pillar of the EM story for investors. The erosion won’t be dramatic – EM policymakers tend to have strong memories of the dangers of balance sheet indiscipline – but it is likely to be steady.

And in the near term, that public sector balance sheet deterioration will be fuelled by another factor: the election cycle. Next year will see elections in a number of large EM economies: Brazil (parliamentary and presidential), India (parliamentary), Indonesia (presidential), South Africa (presidential), and Turkey (local and presidential). Although there is no evidence of fiscal blowout in any of these countries now, fiscal consolidation will be a tough ask. And, as we’ve learned recently, weak import demand in the G10 and a slower China are not the only external shocks that EM faces: the prospect of tighter U.S. monetary policy is also taking its toll. With all of these pressures, EM policymakers will need to tread carefully as they use public sector balance sheets to absorb the various shocks that are threatening. Going forward it will be that much more difficult for EM to convince the rating agencies that the steady improvement in sovereign creditworthiness we’ve seen since 2004 can continue.

*The Group of Ten (G10) countries include Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United Kingdom, and United States.

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