THE GLOBAL ECONOMIC ENVIRONMENT FOR EMERGING MARKETS JEFFREY FRANKEL HARPEL PROFESSOR OF CAPITAL...

THE GLOBAL ECONOMIC ENVIRONMENT

FOR EMERGING MARKETS

JEFFREY FRANKEL

HARPEL PROFESSOR OF CAPITAL FORMATION AND GROWTHHARVARD UNIVERSITY

ANNUAL SYMPOSIUM ON CAPITAL MARKETSMEDELLIN, COLOMBIA, MAY 3, 2012

TWO - SPEED RECOVERY:EMS BOUNCED BACK FROM THE 2008-09 GLOBAL

RECESSION MORE STRONGLY THAN ADVANCED ECONOMIES

World Economic Outlook, IMF, April 2012

EM RECOVERY FROM THE GLOBAL RECESSION CONTINUES STRONGER THAN USUAL,

BUT NOT SO FOR ADVANCED ECONOMIES.

SINCE LAST YEAR, THE IMF HAS REVISED 2012 GROWTH ESTIMATES DOWN SLIGHTLY, ESP. FOR EUROZONE.


Euro-recession is pulling down growth.

Emerging Market growth is slowing too, but solidly >0.

The US is doing better.

Rate of growth of real GDP (%), Projections for 2012 & 2013


FOUR BIG RISKS THREATEN THE GLOBAL OUTLOOK

• “Big” means, not “high probability” per year,• but probability > 20% per year,• with big consequences if it were to happen.

• 1) New € crisis => • more defaults on periphery, higher spreads

even in northern Europe & possible break-up of €-zone.• 2) New partisan US budget stand-off.

• 3) Return of “risk off”; EMs hit?

• 4) Commodity price volatility• E.g., world oil prices double again.

(1(1) THE CRISIS OF SOVEREIGN DEBT) THE CRISIS OF SOVEREIGN DEBTIN THE EURO PERIPHERY WILL IN THE EURO PERIPHERY WILL

RETURNRETURN

• The flash point right now is Spain.The flash point right now is Spain.

• The trigger in a year could be Greece, again:The trigger in a year could be Greece, again:• Greece cannot get back to a sustainable debt path Greece cannot get back to a sustainable debt path

by austerity, as has been clear for awhile.by austerity, as has been clear for awhile.• When it eliminates its primary budget deficit, When it eliminates its primary budget deficit,

no more incentive to keep servicing debt. => default.no more incentive to keep servicing debt. => default.• By then Euro banks may no longer have life-threatening exposureBy then Euro banks may no longer have life-threatening exposure

• having passed debt to ECB, EFSF…+ provisioned.having passed debt to ECB, EFSF…+ provisioned.• With default, Greek exit from euro begins to make sense.With default, Greek exit from euro begins to make sense.

• Or Portugal or Italy. Regardless, contagion to others.Or Portugal or Italy. Regardless, contagion to others.• This time it will probably hit France as well.This time it will probably hit France as well.

• Could contagion reach other high-debt countries?Could contagion reach other high-debt countries?• UK? Japan? US?UK? Japan? US?

ACROSS ADVANCED COUNTRIES, DEBT/GDP IS ALMOST THE HIGHEST IN A

CENTURY, SECOND ONLY TO WWII SPIKE

(2) US DEFICIT WOES WILL RETURN

• The US has mismanaged its finances as badly as Europe.• The US doesn’t have the excuse of 17

legislatures,• just two deadlocked political parties.

• It is a long-term problem:• i) Future deficits in “entitlement spending”

• social security & Medicare.

• ii) Current budget deficits since 1981• Steps in 1990s to restore surplus worked,• but were reversed in 2001.

THE US NATIONAL DEBT AS A SHARE OF GDPSOURCE: CBO, MARCH

ONE OBSTACLE, ABOVE ALL OTHERS

• One of the two political parties has been hi-jacked by a minority who say fiscal balance is urgent, but also say it can be done entirely by cutting domestic spending:• They want to cut taxes & raise military spending at

the same time as eliminating the deficit,• which is mathematically impossible.

• Prevents any sort of deal like 1990• which slowed spending growth

& raised taxes during the 1990s.

THE GAME OF “CHICKEN”

In the 1955 movie Rebel Without a Cause, whoever jumps out of his car first supposedly “loses” the game.

James Dean does; but the other guy miscalculates and goes over the cliff.

THE DEBT-CEILING GAME OF “CHICKEN”

• In the summer of 2011, “fiscal conservatives” recklessly threatened government default, if their demands were not met.• The resulting political dysfunction led S&P

to downgrade US bonds from AAA to AA.

• A last-minute solution postponed the deadline to the end of 2012:• If no action is taken then, (i) all tax cuts expire,

(ii) all discretionary spending is cut drastically, & (iii) the debt ceiling law is probably violated anyway.

• I.e., a return of the stand-off:• => Danger of recession and default !

3) RETURN OF “RISK OFF” ENVIRONMENT?

• Financial markets have swung back and forth between periods of risk-denying “reach for yield” & periods of risk-obsessed “flight to safety.”

• Risk perceptions were far too low in 2003-07.• Shot up in 2008-09;• Down in 2010-11.• Up again?

SOVEREIGN SPREADS DEPEND ON RISK PERCEPTIONS, AS REFLECTED IN THE VIX

(OPTION-IMPLIED VOLATILITY OF US STOCK MARKET)

Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011

Risk on

Riskon

Riskoff

ARE EMS VULNERABLE?

• Historically, international financial shocks (a rise in risk-aversion and/or interest rates) hit Emerging Markets harder than anyone:• 1982: International debt crisis (esp. Latin America)• 1997: East Asia crisis (spreading to Russia, Brazil…).

• Worryingly, EMs seem subject to15-year cycle: • 7 years of capital inflow drought;• 7 year of capital inflow flood;• Crisis hits in 15th year.

THE BIBLICAL CYCLETHE BIBLICAL CYCLE

• Joseph prophesied 7 years of plenty, Joseph prophesied 7 years of plenty, with abundant harvests from a full Nile with abundant harvests from a full Nile -- followed by 7 lean years of drought & famine. -- followed by 7 lean years of drought & famine.

• The Pharaoh empowered his technocratic official The Pharaoh empowered his technocratic official (Joseph) to save grain in the 7 years of plenty,(Joseph) to save grain in the 7 years of plenty,• building up sufficient stockpiles to save the Egyptian people building up sufficient stockpiles to save the Egyptian people

from starvation during the bad years.from starvation during the bad years.• -- a valuable lesson for today’s government officials in industrialized & -- a valuable lesson for today’s government officials in industrialized &

developing countries alike.developing countries alike.1717

BIBLICAL CYCLE, CONTBIBLICAL CYCLE, CONT..

• For emerging markets, the first phase of 7 years For emerging markets, the first phase of 7 years of plentiful capital flows occurred in 1975-1981, of plentiful capital flows occurred in 1975-1981, • recycling petrodollars as loans to developing countries. recycling petrodollars as loans to developing countries.

• The international debt crisis that began in Mexico The international debt crisis that began in Mexico in 1982 was the catalyst for the 7 lean years, in 1982 was the catalyst for the 7 lean years,

• known in Latin America as the “lost decade.” known in Latin America as the “lost decade.”

• The turnaround year, 1989, saw the first issue of Brady bonds, which helped The turnaround year, 1989, saw the first issue of Brady bonds, which helped

write down the debt overhangwrite down the debt overhang • and put a line under the crisis.and put a line under the crisis.

1818

BIBLICAL CYCLE, CONTBIBLICAL CYCLE, CONT..

• The second cycle of 7 fat years was the period of record The second cycle of 7 fat years was the period of record capital flows to emerging markets in 1990-96.capital flows to emerging markets in 1990-96. • The 1997 “sudden stop” in East Asia The 1997 “sudden stop” in East Asia

was then followed by 7 years of capital drought. was then followed by 7 years of capital drought.

• The third cycle of inflows, often identified with The third cycle of inflows, often identified with “carry trade” and “BRICs” came in 2004-2011“carry trade” and “BRICs” came in 2004-2011 • and persisted even through the Global Financial Crisis. and persisted even through the Global Financial Crisis.

• If history repeats itself, it is now time for a 3If history repeats itself, it is now time for a 3rdrd sudden stop of capital flows to emerging markets!sudden stop of capital flows to emerging markets! 1919

ARE EMERGING MARKETS DUE FOR A ARE EMERGING MARKETS DUE FOR A CORRECTION, TRIGGERED BY A NEW WAVE CORRECTION, TRIGGERED BY A NEW WAVE

OF “RISK OFF” BEHAVIOROF “RISK OFF” BEHAVIOR??

• Most worrisome: Turkey.Most worrisome: Turkey.• Turkey can probably not sustain the rapid economic growth Turkey can probably not sustain the rapid economic growth

and very high trade deficits of recent years. and very high trade deficits of recent years.

• Vulnerable to world oil price.Vulnerable to world oil price.

• China could land hard as its real-estate bubble deflates China could land hard as its real-estate bubble deflates and the country’s banks are forced to work off bad loans.and the country’s banks are forced to work off bad loans.

• High GDP growth rates in Latin America High GDP growth rates in Latin America over the same period could reverse,over the same period could reverse, • particularly if global commodity prices fall – particularly if global commodity prices fall –

• Esp. if the cause is that the Chinese economy begins to falter. Esp. if the cause is that the Chinese economy begins to falter. 2020

2121

BUT: A REMARKABLE ROLE-REVERSALSUGGESTS EMERGING MARKETS

ARE NO LONGER SO VULNERABLE:

• Debt/GDP of rich countries (> 80%) is nowmore than twice that of emerging markets;

• and rising rapidly. +• Even EM “debt intolerance” may be diminishing.

• ≡ creditworthiness for given debt/GDP -- Reinhart & Rogoff

=>• Some EMs Economies are now more creditworthy than some Advanced Economies

• as reflected in credit ratings or sovereign spreads.

BUT WEAKER IN ADVANCED ECONOMIES.


Public finances since 2001have become much stronger in

EMs

COUNTRY CREDITWORTHINESS COUNTRY CREDITWORTHINESS IS NOW INTER-SHUFFLEDIS NOW INTER-SHUFFLED

““Advanced” CountriesAdvanced” Countries (Formerly) “Developing” Countries(Formerly) “Developing” Countries

AAA Germany, UKAAA Germany, UK Hong Kong, SingaporeHong Kong, Singapore

AA+ AA+ US, FranceUS, France

AA-AA- JapanJapan ChinaChina

A+A+ Chile, KoreaChile, Korea

A-A- Malaysia, BotswanaMalaysia, Botswana

BBB+BBB+ Ireland, Italy, Spain Ireland, Italy, Spain South Africa, ThailandSouth Africa, Thailand

BBBBBB Brazil Brazil

BBB-BBB- IcelandIceland Colombia, India, IndonesiaColombia, India, Indonesia

BBBB PortugalPortugal Costa Rica, Jordan, PhilippinesCosta Rica, Jordan, Philippines

BB Burkina FasoBurkina Faso

CCCC GreeceGreece

S&P ratings, Apr.26, 2012

ONE INDICATION OF IMPROVED EM CREDITWORTHINESS: EM SOVEREIGNS USED TO HAVE TO PAY HIGHER INTEREST RATES

THAN US HIGH-YIELD CORPORATES (BB), BUT NOW PAY LESS.


Copyright Jeffrey Frankel,

HISTORIC ROLE REVERSAL IN THE CYCLICALITY OF FISCAL POLICY IN INDUSTRIALIZED VS.

DEVELOPING COUNTRIES

• In the textbooks, benevolent governments are supposed use discretionary fiscal (& monetary) policy to dampen cyclical fluctuations.

• expanding at times of excess supply, and• contracting at times of excess demand.

• But in practice, …

Copyright 2007 Jeffrey Frankel, unless otherwise noted

PRO-CYCLICAL FISCAL POLICYTHESE 3 PAGES WERE IN L3 APP. IN 2010

In practice, policy has often been procyclical, i.e., destabilizing, in developing countries:

• Governments would raise spending in booms;• and then be forced to cut back in downturns.

• Kaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006), Ilzetski & Vegh (2008) and Medas & Zakharova (2009).

• Especially Latin American commodity-producers.• Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003),

Perry (2003), and Villafuerte, Lopez-Murphy & Ossowski (2010).

procycl

ical }

G always used to be pro-cyclical for most developing countries.

countercycl

icall

Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”

Pro-cyclical spending

Counter-cyclical spending

Correlations between Gov.t Spending & GDP1960-1999

AN IMPORTANT DEVELOPMENT -- IN THE LAST DECADE, SOME DEVELOPING COUNTRIES

WERE ABLE TO BREAK THE HISTORIC PATTERN:

• They took advantage of the 2003-08 boom • to run budget primary surpluses.

• and build reserves.

• By 2007, Latin America had reduced its debt • to 33% of GDP, • as compared to 63 % in the United States.

• And so had fiscal space to respond to the 2008-09 recession.

• I.e., some emerging market countries finally achieved countercyclical fiscal policies.

CORRELATIONS BETWEEN GOV.T SPENDING & GDP

2000-2009

In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (2011)

procyclic

al

countercyclic

al

TO SUMMARIZE THE FISCAL ROLE REVERSAL,

• Many important emerging markets have, so far this century, achieved:• Lower debt levels than advanced

economies;• improved credit ratings;• lower sovereign spreads; and• less procyclical fiscal policies.

LESS VULNERABLE TO CRISESIN OTHER RESPECTS AS WELL:

• More flexible exchange rates than before 1997.• Higher fx reserve holdings

• E.g. relative to short-term debt.

• Less prone to current account deficits.

• Capital inflows less concentrated in $ bank debt• And local-currency debt.• More FDI.

• Exception: the one region that apparently didn’t learn the lessons of the 1990s was Eastern Europe.

(4) COMMODITY PRICE

VOLATILITY• Prices of oil, minerals & agricultural commodities

have become increasingly volatile in recent years.

• Especially sharp spikes in 2008 & 2011• With a crash in between.

• Commodity price volatility likely to continue.

• Whether a commodity price rise is good or bad depends on• (i) whether you are a buyer or seller• (ii) the cause of the increase.

COMMODITY PRICES HAVE BEEN ESPECIALLY VOLATILE OVER THE LAST DECADE

0

20

40

60

80

100

120

140

160

180

60 61 63 64 66 67 69 71 72 74 75 77 79 80 82 83 85 86 88 90 91 93 94 96 98 99 01 02 04 05 07 09 10

in prices of 2010 In prices of 2000*

Commodity prices: all commoditiesIndices

*) Deflated by US consumer price index.Source: HWWA, Datastream.

Nominal prices2010=100

Real prices * = nominal in 2000

A.Saiki, Dutch Nat.Bk.

COMMODITY PRICES SPIKED IN 2008, AND AGAIN IN SPRING 2011

Oil


WHAT DETERMINES COMMODITY PRICES?

• Various idiosyncratic factors in each sector.• When wheat prices go up, it could be Australian

drought, Russian fires, Canadian floods, US ethanol subsidies or Argentine export controls.

• But when virtually all commodity prices move together, it must be macroeconomic:• 70s↑, 80s↓, 2002-08 ↑ , 2008-09↓, 2009-11↑.

• Leading explanation: global business cycle, e.g., China-led growth 2002-08 & 2010-11.

• Secondary explanation: monetary policy, • as reflected in real interest rates.

GROWTH IN CHINA’S IMPORTS OF MINING PRODUCTS IS A BIG REASON FOR THE UPWARD

TREND IN THEIR PRICES.


OIL PRICES HAVE CONTINUED TO RISE IN 2012.THEY COULD GO MUCH HIGHER, OR MUCH LOWER.

• This has been idiosyncratic, not a continuation of the general commodity boom.• E.g., natural gas prices are strongly down,

• at least in the U.S.

• It is attributable to geopolitical risk:• Tensions with Iran.

• Sanctions on Iranian oil exports.• The danger of military conflict

• which might impede access to oil from the Persian Gulf.

COLOMBIA, LIKE MOST LATIN AMERICAN COUNTRIES, IS VULNERABLE TO

FURTHER SWINGS IN PRICES OF COMMODITIESESP. OIL & COFFEE

• Dangers of commodity volatility include:• Highly cyclical revenues;• Real currency appreciation crowding out manufacturing• Procyclical fiscal policy;• Procyclical monetary policy.

CONTRACT DEVICES TO SHARE CONTRACT DEVICES TO SHARE RISKSRISKS

1.1. Index contracts with foreign companiesIndex contracts with foreign companiesto the world commodity price.to the world commodity price.

2.2. Hedge commodity revenues Hedge commodity revenues in options marketsin options markets

3.3. Denominate debt Denominate debt in in terms of terms of commoditycommodity

price:price: Issue oil bonds Issue oil bonds & & coffee bonds, instead of $ or peso coffee bonds, instead of $ or peso

bonds.bonds.

Risk-manangement recommendations for commodity-exporting countries

4. Allow some currency appreciation in response 4. Allow some currency appreciation in response to a rise in world prices of export commodities, to a rise in world prices of export commodities, but not free floating. Accumulate some forex reserves.but not free floating. Accumulate some forex reserves.

5. 5. If the monetary regime is to be Inflation Targeting, If the monetary regime is to be Inflation Targeting, consider using as the target, in place of the CPI, consider using as the target, in place of the CPI, a price measure that puts weight a price measure that puts weight on the export commodity on the export commodity (P(Productroduct PPricerice TTargetingargeting).).

6. Emulate Chile: to avoid over-spending in boom 6. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only times, allow deviations from a target surplus only in response to permanent commodity price risesin response to permanent commodity price rises..

Recommendations for commodity producers continued

COUNTER-CYCLICAL MACROECONOMIC POLICYCOUNTER-CYCLICAL MACROECONOMIC POLICY

PPT

7. Manage Commodity Funds 7. Manage Commodity Funds transparently & professionally, transparently & professionally,

like Botswana’s Pula Fundlike Botswana’s Pula Fund -- -- notnot subject to politics subject to politics like Norway’s Pension Fund.like Norway’s Pension Fund.

8. Invest in education, health, & roads.8. Invest in education, health, & roads.

9. Buyers: Publish What You Pay. 9. Buyers: Publish What You Pay.

Recommendations for commodity producers, concluded

GOOD GOVERNANCE GOOD GOVERNANCE INSTITUTIONSINSTITUTIONS

ELABORATION ON TWO PROPOSALS TO REDUCE THE PROCYCLICALITY

OF MACROECONOMIC POLICY FOR COMMODITY EXPORTERS

• I) To make monetary/exchange rate policy less procyclical: Product Price Targeting

• II) To make fiscal policy less procyclical: emulate Chile.

PPT

I) THE CHALLENGE OF DESIGNING A CURRENCY REGIME FOR COUNTRIES WHERE

TERMS OF TRADE SHOCKS DOMINATE THE CYCLE

• Floating accommodates terms of trade shocks,• thus giving countercyclical monetary policy;• but can entail excessive

exchange rate movement • and does not provide a nominal anchor.

• Inflation targeting, in terms of the CPI,• provides a nominal anchor;• but can dictate a procyclical monetary policy.

Professor Jeffrey Frankel

Product Price Targeting

Target an index of domestic production prices. [1]

• Include export commodities in the index and exclude import commodities,

• so money tightens & the currency appreciates when world prices of export commodities rise,

• not when world priced of import commodities rise.• Automatically countercyclical.

• The CPI does it backwards:• It calls for appreciation when import prices rise,• and not when export prices rise.

[1] Frankel (2011).

PPT

THE GLOBAL ECONOMIC ENVIRONMENT FOR EMERGING MARKETS JEFFREY FRANKEL HARPEL PROFESSOR OF CAPITAL...

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