With the markets starting off the year on a weak note (to say the least) and worries related to the Chinese economy playing a central role in this brisk year debut, a paper published by the World Bank on Thursday is highly relevant. As part of its publication on global economic outlook, the bank included a detailed analysis of the possible spillovers from emerging markets.
One of the main highlights of the report is that emerging and frontier economies are more susceptible to a slowdown in the BRICS (Brazil, Russia, India, China and South Africa) with a 1 percentage point (pp) decline in BRICS growth found to bring down the growth in emerging markets by 0.8 pp in the following two years. Meanwhile, for the frontier economies the estimated impact was put at 1.5 pp, reflecting the lower smaller size of the latter and their limited diversification.
For the G7 countries on the other hand no statistically significant correlation was found which was attributed to their headroom in terms of countercyclical policies particularly given their net oil-importing countries. Even so, this empirical finding comes with a disclaimer that said “slowdowns in BRICS can weigh on growth in individual advanced markets that have strong trade links with the BRICS, notably Germany and Japan. Confidence effects-although not explicitly captured econometrically here- could amplify spillovers”.
Indeed, quantifying the latter is likely what is challenging investors the most at the moment as in my opinion a rapid slippage in confidence and the associated tightening in financial conditions will add to the downside risks in a way which becomes hard to project; historical experience might provide limited insight given the changes in the global economy over the last decade (with emerging markets becoming larger and more integrated), the unicity of the current monetary conditions and fears of currency wars.
The think-tank also looked into the drivers of the growth slowdown in the BRICS and points out that since 2014 domestic rather than external factors have played a central role. To put it differently, whereas between 2011-13 weaker global trade and a turn in the commodities supercycle were to blame for the tapering of the growth rates, more recently country-specific challenges have gained in importance.
“On average across emerging markets, longer-term structural factors may have accounted for about one third of the growth slowdown in 2010-14. In individual countries, however, the contribution of structural factors has ranged from one-tenth to virtually all of the slowdown since 2010”. This implies that a return to pre-crisis growth rates will not be forthcoming as efforts will need to be channelled towards lifting the productivity.
The BRICS slowdown in turn appears “to have accounted for the bulk of the growth slowdown in other emerging markets and frontier markets between 2010 and 2015”. Not all BRICS are alike though, with the slowdown in China found to impact growth worldwide while lower growth in Brazil, India and South Africa poses manageable risks.
Overall the report confirms that emerging markets have become more pivotal for global growth as their economies and financial markets have become more integrated in the global web. The outlook poses significant uncertainties given that (i) most of them face limited headroom in terms of monetary and fiscal policies (ii) the slowdown is partially due to structural headwinds rather than mere cyclical contagion in the aftermath of the crisis and (iii) confidence shocks can have far reaching and hard to estimate effects following several years of strong portfolio flows into the emerging financial markets, particularly as Fed has recently lift its key rate.
Regarding the latter, the World Bank notes “when combined with tightening financial conditions, e.g. EMBI increasing by 100 basis points from the current level in 2015 (an increase comparable to the taper tantrum), the BRICS slowdown could cut growth in other emerging markets by about 1.3-1.5 percentage points and in the frontier markets by 1-1.8 from the baseline forecast for 2016-17.”
Against this backdrop, I would expect heightened volatility to remain a constant over the next few weeks with investors shying away from adding significantly to emerging market names and safer assets continuing to see sustained demand notwithstanding the low yields in offer. A sustainable change in trend would from my point of view necessitate an easing in emerging markets growth related worries. As the World Bank highlights “with every year of slowing BRICS growth, the probability increase that the slowdown turns into an outright recession”.
Have a nice day!
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