Download The New Financial Landscape: What It Means

THE WORLD BANK
POVERTY
REDUCTION
AND ECONOMIC
MANAGEMENT
NETWORK (PREM)
Economic Premise
SEPTEMBER
JUN 2012
010 •• Number
Numbe 87
18
The New Financial Landscape: What It Means for
Emerging Market Economies
Otaviano Canuto, Catiana García-Kilroy, and Anderson Caputo Silva
As the year 2012 unfolds, its main legacy will be its game changing impact on global financial markets. Waning global
growth along with central banks’ bold monetary easing policies in advanced economies (AEs) to try to reverse it are
changing market dynamics in unexpected ways, across both AEs and emerging market economies (EMEs). The combination of monetary stimulus, fiscal austerity and hesitant structural economic policy reforms in AEs, particularly in
Europe, is taking the global financial system into increasingly uncharted territory. How the European Union will
address the future of the eurozone, including uncertainties over its banking sector, as well as how the United States
handles its Fiscal Cliff,1 will weigh heavily on economic balances across all economies worldwide. This seems to be a
significant point of inflection on the speed of the rebalancing of economic relevance of AEs in favor of EMEs taking place
over the last 12 years. Under this scenario, the ability of EMEs to handle their own fiscal, financial, and real economy
weaknesses is critically tied to their ability to weather external shocks and take advantage of growing global savings
while searching for yield and growth opportunities.
A New Financial Landscape
Policies to manage global macrofinancial instabilities are leading to, at best, challenge existing assumptions of risk valuation
and capital allocation. The new global scenario entails a persistent, stronger presence of governments and/or central
banks in asset pricing. This trend is reflected through several
channels, among which the most important are: (i) monetary
easing programs of various sorts in AEs are flattening yield
curves and bringing long-term yields to historic low levels; (ii)
liquidity regulations are creating a sizeable captive demand
for government bonds, implying further drops in yields; (iii)
public sector interventions to support banks either through
bailouts and generous liquidity facilities are creating distor-
tions in their cost of funding compared to other issuers; (iv)
currency manipulation has become a widespread behavior
across AEs and EMEs, generally to mitigate currency appreciation (Gagnon 2012), but also to reduce volatility; and (v)
central banks’ balance sheets have expanded to unseen levels
in both AEs and EMEs, for different reasons, but with consequences on the economy and the financial sector still to be
assessed.2
While the new scenario is still being defined, market allocation strategies are guided by bursts of alternate risk-on
and risk-off capital flows. The underlying trend is a “flight-tosafety” mainly targeting G-4 economies,3 which is creating
unprecedented low yields in government debt despite low
growth prospects and high fiscal imbalances (figure 1).
1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise
Figure 1. Ten-Year Government Bond Yields
6
percent
5
4
3
2
1
0
Dec-06
Jun-07
Dec-07
Jun-08
United States
Dec-08
Jun-09
Dec-09
United Kingdom
Jun-10
Japan
Dec-10
Jun-11
Dec-11
Jun-12
Germany
Source: Bloomberg.
Where Do EMEs Stand?
percent
other regions such as Brazil, the Russian Federation, and
South Africa.
This does not mean that the structural shift rebalancing
Vulnerabilities in EMEs cannot be overlooked because
EMEs weight in relation to AEs that seemed to be consolidatthey
combine external factors and home-grown imbalances.
ing after the 2008 crisis is in doubt.4 On the contrary, the
The former include volatile capital flows amid depreciating
trend is still there, but its pace has slowed down temporarily,
currencies, dependency on single exporting products and comand it is still an open question whether the structural rebalmodities, as well as the potential fatal impact of prices increases
ancing favoring EMEs will resume the faster track observed in
for soy, corn, and wheat after the drought in the United States,
recent years.
putting pressure on inflation through food prices, together
There are differences between regions depending on
with weaker prices for metals affecting growth (figure 3).
where each country stands and its exposure to AE’s retrenchDomestic weaknesses include the fact that large EMEs are
ing banking sector, direct trade dependency on AEs, or comat the end of the credit cycle (IMF 2012a), and that physical
modity exports. However, some common patterns may be
infrastructure is still deficient across all EMEs. Both factors are
drawn.
constraining EMEs’ growth potential, even in a scenario of fisOn the negative side, expected gross domestic product
cal and monetary stimulus.
(GDP) growth in EMEs and developing economies for 2012
On the positive side, EMEs have fiscal and monetary
and 2013 has been downgraded several times in a row, and is
space to take counterbalancing measures, given their lower fisnow expected to be 5.6 and 5.9 percent respectively (IMF
cal debt and relative high interest rates when compared to AEs
2012b), well off its postcrisis peak of 7.5 percent in 2010 (fig(IMF 2012a). Central banks have already been conducting
ure 2). China’s GDP growth has also been hit, as shown by the
monetary easing by lowering policy rates and reserve require7.6 percent figure released for the second quarter of 2012,
ments in all regions. The most conspicuous example is Brazil,
down from 8.1 percent in the first quarter. This will drag
which has lowered its policy rate by 450 basis points in less
down most Asian economies and commodity exporters in
than a year. Other large EMEs, such as China, India, Indonesia, Turkey, and South Africa have also
Figure 2. GDP Growth: EMEs versus AEs
eased monetary conditions with the consequence
10
of depreciating currencies. The big question is
8
whether these measures will be as effective as
during the 2008 crisis given EMEs’ mentioned
6
structural constraints and stronger economic im4
balances in AEs.
2
Credit ratings are still holding for all EMEs,
0
but
India’s
risk of being the first of the BRIC
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
-2
members (Brazil, Russia, India, and China) to
-4
lose investment grade status after S&P’s negaadvanced economies
emerging economies
tive outlook in April is a warning for other
-6
EMEs. As global economic conditions get
Source: IMF 2012b (and July update).
Note: 2012 and after are projections.
2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise
aluminum
copper
corn
12
12
wheat
20
ly
Ju
ne
Ju
ay
20
20
12
2
01
M
Ap
ril
2
ar
M
b
Fe
Ja
20
12
20
12
20
n
20
c
De
12
150
140
130
120
110
100
90
80
70
60
11
Commodity Price Index
(Dec 31, 2011 = 100)
Figure 3. Divergent Commodity Prices
soybean
Source: Bloomberg.
tougher, there will be a clearer differentiation favoring
EMEs that are able to continue with structural reforms.
An Uncertain Scenario for Investment
Allocations and Capital Flows to EMEs
The changing financial landscape, the enduring crisis in developed economies, and the downward revisions in global
growth are setting the tone for investment allocations and
capital flows to EMEs. The prevailing uncertainty of outcomes and duration of these key drivers are having at least
three major consequences on flows and preferences across
assets classes:
i. A great share of global liquidity is piling up and sitting on
the fence: flight-to-safety, especially to G-4 sovereign
debt, is undermining potential investments and slowing
the pace of portfolio allocations to emerging market assets.
ii. Volatility of capital flows to EMEs has increased: equity
markets are being more severely impacted, influenced by
risk-on and risk-off behavior, and mirroring the uncertainty of growth outlooks. Already in the first half of
2012, for example, equity markets in EMEs have experienced large swings in capital flows, starting with a buoyant period in the first two months, a sharp reversal up to
May, and a recovery by the end of June (figure 4).
iii. Flows to EMEs’ (sovereign and corporate) bonds have
been comparatively more stable and concentrated on
hard currency: volatility of bond flows has so far been
just a fraction of that observed in equity markets, with
80 percent of EME fixed-income flows in the first half of
2012 directed toward hard currency instruments (JP
Morgan 2012).
Against this backdrop, sovereign and corporate emerging market bonds in hard currency—represented by the
EMBIG and CEMBI indices, respectively—have performed
consistently well both over a period of one year and year to
date (figure 5). Commodities and EME equity returns have
been disappointing and volatile in line with the global
downturn.
Looking forward, volatility in capital flows seems unlikely to dissipate while global uncertainties remain, but whether
hard currency EME assets will continue to deliver strong performance is less predictable. Compressed EMBIG and CEMBI spreads, the renewed cycle of easing monetary policies in
EMEs, and adjusted levels of exchange rates in several of these
economies may make the selection between hard and local
currency assets less straightforward.
Figure 4. EMEs Inflows and Prices
120
4
115
3
2
110
1
105
0
1
Dec 30, 2011 = 100
US$ billions, 4-week average
5
100
2
3
Jan 2012
95
Feb 2012
March 12
April 2012
May 2012
June 2012
local bond inflows (left scale)
equity inflows (left scale)
foreign exchange performance (right scale)
MSCI EM equity index (right scale)
Source: IMF 2012a (July 16).
3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise
Adding to the uncertainty of capital flows to EMEs is a
whole suite of regulations to bring under control some of the
triggers of the 2008 financial crisis, such as liquidity requirements on banks and insurance companies through higher
government bond holdings and the Volcker rule banning U.S.
banks from proprietary trading.
and increased weight of domestic demand in GDP
growth.
ii. The risk of asset misallocation caused by two factors—
current distortions leading to too low yields (for example, asset bubbles and misallocated capital), and the excessive role of the state in capital allocation to
counterbalance the downturn.
iii. The persistence of the downturn in AEs impacting
EMEs’ growth through the channels of trade, banks, and
capital flows.
Selecting Policies to Weather the Crisis and
Resume Sustainable Growth
Gloom for AEs is gloom for EMEs as well. However, there will
be a great difference between countries when global growth
resumes on a more stable basis. The challenge is to work on a
mix of policies that can mitigate the impact of the global crisis
while better preparing these economies to tap savings from
AEs when the crisis is over. Prudent macroeconomic policy is
a prerequisite for EMEs’ continuous good performance, but it
does not guarantee success under the current scenario, where
countries are exposed to external shocks beyond their control. How each country is able to manage the following three
risks will determine its position to take advantage of external
savings:
i. Excessive exposure to the global economy and little room
to maneuver in the persistent downturn (for example,
high dependency on trade and commodity exports). The
challenge is to implement structural reforms leading to
fiscal sustainability, broader economic diversification,
Acknowledgment
The authors would like to thank Olga Akcadag and Ying Ling
for their excellent research support. This note is based upon
the forthcoming “Foreword” in the 2013 Euromoney Emerging
Markets Handbook. The content and design has been adapted
for the Economic Premise series.
About the Authors
Otaviano Canuto is Vice President and Head of the Poverty
Reduction and Economic Management (PREM) Network of
the World Bank. Catiana García-Kilroy is a Senior Securities
Markets Specialist and Anderson Caputo Silva a Lead Securities Market Specialist, both in the Securities Markets Group
of the Financial and Private Sector Development (FPD) Network of the World Bank.
Notes
Figure 5. Returns by Asset Class as of August 1, 2012 (%)
12.1
12.8
EMBIG
9.5
9.4
U.S. high yield
9.5
CEMBI broad
GBI -EM Global Div.
6.7
9.4
-1.1
9.4
S&P 500
6.9
7.6
U.S. high grade
10.4
4.1
EM equities
-16.9
2.5
GBI U.S. (UST)
gold
2.3
-1.2
2.3
3.6
ELMI+
-10.3
commodities
year to date
Source: JP Morgan 2012.
7.8
0.2
one year
1. The U.S. Fiscal Cliff refers to the convergence of the
expiration of tax cuts and automatic spending cuts
agreed upon in the U.S. Congress, which will be triggered at the end of 2012. The U.S. Congressional Budget Office estimates that they will cut GDP by 4 percentage points in 2013.
2. In the case of AEs, the origin of expanded balance
sheets was the purchase of domestic assets to ease monetary conditions, while in the case of EMEs it was related to funding the accumulation of foreign reserves either for precautionary reasons or to manage the
exchange rate. See an interesting analysis of Asia and
further references in Filardo and Yetman (2012).
3. G-4 countries are Germany, Japan, the United Kingdom, and the United States. Other countries perceived
as low risk but with lower capital absorption capacity
because of their smaller size, such as Switzerland, Denmark and Sweden, are also being used as safe havens.
4. As highlighted in Canuto (2010) and Canuto, GarcíaKilroy, and Silva (2011).
References
Canuto, O. 2010. “Toward a Switchover of Locomotives in
the Global Economy.” Economic Premise 33, World Bank,
4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise
Washington, DC. http://siteresources.worldbank.org/INTPREMNET/Resources/EP33.pdf.
Canuto, O., C. García-Kilroy, and Anderson Caputo Silva. 2011.
“Foreword.” In Euromoney Emerging Markets Handbook 2012.
Colchester, UK: Euromoney Yearbooks, www.euromoneyyearbooks.com/handbooks.
Filardo, Andrew, and James Yetman. 2012. “The Expansion of
Central Bank Balance Sheets in Emerging Asia: What Are the
Risks?” BIS Quarterly Review June.
Gagnon, Joseph E. 2012. “Combating Widespread Currency
Manipulation.” Policy Brief, Peterson Institute for International
Economics, Washington, DC.
IMF (International Monetary Fund). 2012a. Global Financial Stability Report. April and July, Washington, DC.
———. 2012b. World Economic Outlook. July, Washington, DC.
JP Morgan. 2012. “Mid-Year 2012 Emerging Markets Outlook.”
The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty
Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect
those of the World Bank. The notes are available at: www.worldbank.org/economicpremise.
5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise