Emerging Economies – Risks of Overheating

Emerging Asia and Latin America continues to lead the global recovery and the decouple from advanced G7 economies (discussed in detail in the second section). In both regions domestic demand has performed well, even as fiscal stimulus has begun to be withdrawn (except in China). Government policies remain, in most cases, highly accommodative, offsetting diminishing support from the inventory cycle and weaker external demand. In Latin America, strength in commodity prices are also supporting the dynamism of economic activity. Although GDP outturns at the end of 2010 were higher than expected (thus raising our estimate of 2010 growth) in our opinion GDP growth in 2011 and 2012 should not deviate significantly from our previous forecasts, except in the case of Mexico.

We still envisage strong growth in China although momentum is likely to slow, given Beijing’s determination to curb lending, tame inflation and cool down the property sector. Government efforts to induce a ‘soft landing’ are likely to include further exchange rate appreciation and targeted measures to take the steam out of the property market, such as implementation of a property tax on a pilot basis in a few large cities. For the rest of emerging Asia, growth will also perform well going forward and average slightly above 4% (chart below). Nevertheless, risks are tilted toward overheating in a number of countries, with inflation beginning to accelerate (figure 2). For the region as a whole, inflation and asset price bubbles are likely to remain a concern, fuelled by capital inflows and low interest rates.

Growth in Latin America exceeded expectations at the end of 2010 due to strong domestic demand, improved terms of trade and capital inflows. Nevertheless, we expect GDP growth to converge to its potential of about 4% for the region as a whole. Investment is playing a major role in the expansion of domestic demand and fiscal and current account balances will continue benefiting from high commodity prices. The outlook has improved substantially in Mexico, highly influenced by the upturn in expectations for the US for 2011 and 2012. Inflation in the Latin American region is higher than in Asia, but it has not accelerated as quickly. Rising food and energy prices, though, could cause some temporary spikes going forward. In any case, risks in South America are also tilted to slight overheating, especially in some countries like Brazil, where the current account has deteriorated rapidly even in the context of a positive terms of trade.

Figure 1: Emerging Economies GDP Growth

 Figure 2: Inflation in Emerging 

Inflation risks start being a concern in emerging regions, fuelled by commodity prices, but also domestic demand pressures

Inflation risks start representing a major risk for emerging economies. We forecast stable commodity prices at around current levels, but with risks tilted to the upside. Especially important are risks derived from an increase in energy and food prices, the latter because of a bigger weight of foodstuffs on CPI indexes in emerging economies as compared with more developed countries. In this respect, some countries are especially at risk, either because their inflation rates already start from a high level (Brazil, India and Vietnam, for example) or because inflation is highly sensitive to an increase in food prices, given their bigger weight in the consumption basket (Peru, Philippines and Vietnam to name a few). Figure 3 below classifies countries in Latin America and Asia according to the first round effect of an increase in food prices, showing that inflation risks are highly heterogeneous within regions. This heterogeneity also extends to the comparison between regions: Asia presents bigger inflation risks both on account of higher starting inflation rates and higher sensitivity to food prices than Latin America.

Figure 3: Risks from First Round Effect of an Additional Increase in Food Prices

Figure 4: Bilateral Exchange Rates to the US Dollar

Notwithstanding this, additional inflation risks also stem from domestic demand pressures, in part fuelled by capital inflows. Rapid growth in emerging economies is narrowing (in some cases even closing) output gaps quickly, bringing with it overheating pressures. These pressures were to some extent contained in the final months of last year, as uncertainty stemming from financial woes in Europe moderated capital inflows to emerging economies. This moderation of inflows was partly reflected in reduced currency appreciating pressures between October and end 2010 (figures 4 and 5) and the decision by some central banks to suspend monetary policy tightening. A reduction in Europe’s financial stress is likely to restart capital inflows.

Figure 5: Equity Capital Flows to Emerging Economies

Going forward, given an expected easing of financial stress in Europe, capital inflows to emerging economies will likely resume, providing further fuel for increases in asset prices and domestic demand pressures. Thus, policy dilemmas already present last year will intensify, challenging policymakers with the trade-off between cooling inflation and domestic demand and allowing further appreciation of their currencies. We expect most central banks to resume their paths of monetary tightening (including credit tightening measures in some countries), as inflation risks mount. At the same time, they will lean heavily against further exchange rate appreciation with strong interventions and some capital controls. However, these measures are unlikely to prevent completely the appreciation of their currencies as experience shows that the effectiveness of intervention is rather limited.

EAGLEs: The key emerging markets of the next 10 years

The decoupling between the growth rates of emerging markets and the developed countries is not, in our view, a cyclical phenomenon. On the contrary, it is a structural feature of the global economy in the medium term. There are several factors behind this view. First, the impact of the crisis and the tolls imposed by its resolution are clearly much larger in the developed markets, where we expect a significant slowdown from the pre-crisis expansionary period. For emerging markets, the drag created by the credit crisis is much less severe and the quick recovery observed in 2010 is proof in our view of this. Looking over the longer term, we have conducted detailed estimates of potential GDP growth based on forecasts for the likely production factors (employment, capital and total factor productivity (TFP)). This comprehensive exercise highlights how the Emerging Markets, as a whole, can rely on a stronger basis for long term growth than the developed economies. In particular, their demographic prospects are better, implying that conservative forecasts over the long term do not require an acceleration in investment or total factor productivity.

Figure 6: Developing vs. Developed Economies

Figure 7: Other Major EM Apart from China and India

In view of this, it is understandable that investors have shown greater interest in finding new ways to position for this rotation in world growth towards the Emerging Markets. We have created an ongoing project to provide information about this issue. This effort is focused around the EAGLEs concept. EAGLEs stands for “Emerging and Growth-Leading Economies” and is the group of emerging markets whose contribution to global growth over the next 10 years is expected to be higher than that of the large industrial countries (which we define as the G6, i.e. the G7 excluding the US). Our approach has several advantages versus alternative acronyms recently launched:

    • Instead of looking at economic size and population, which may be misleading, EAGLEs focuses on the incremental GDP (IGDP) economies will generate instead, that is, their contribution to world growth. The use of IGDP is key: having a big size or a high growth rate is not enough on its own to be a key global player; it is the combination of both that really matters. This is a more relevant concept for identifying business and market opportunities with more anticipation (figures 6 and 7 above).
    • Dynamic: it is updated each year on the basis of economic performance and changes in economic conditions, as reflected in our forecasts. It is not a closed group and the concept is not linked to an acronym formed by a given set of countries. This will allow identifying key markets in the EM universe and warn about potential “fallen angels” in advance.
    • Objective: the criterion for inclusion is explicit. In order to become an EAGLE each country’s expected incremental GDP in the next 10 years needs to be greater than the one anticipated for the average of the G7 economies, excluding the US.
  • The results are based on a shorter horizon (i.e. 10 years) than the ones considered in other cases, ranging from 20 to 50 years, as global economy may experience huge changes in such a long period of time. This horizon is more relevant for most investment decisions.

Who are the EAGLEs? Some surprising results are highlighted by our methodology. According to our forecasts, world GDP in the current decade will increase by 41 trillion US dollars adjusted by PPP. The EAGLEs contribution (their IGDP) will be slightly over 50% whereas the G7 share will only be 14%. It is worth highlighting China’s expected role in the next ten years; its contribution to total world growth will account for almost 30% of world growth, four times more than the US and 2.4 times more than the other three BRIC countries. India will actually match the US contribution to growth, even if its GDP will still be lower by 2020. Brazil will be the third biggest contributor, followed by Indonesia and South Korea (chart 7, above). Note that Indonesia and South Korea will each contribute to world growth more than Russia, and if combined these two economies will generate 1.5 times more incremental GDP than Brazil. This is a clear case where the relevance of the BRIC concept is challenged. Next on the list is Mexico, whose IGDP contribution is expected to be greater than the one of Germany or the UK, in spite its current GDP size adjusted by PPP being only 53% and 71% of them respectively. Finally it is Egypt, Turkey and Taiwan; each economy’s IGDP is expected to be higher than that of Canada, France and Italy. The non-EAGLE BRICs will be more relevant for world growth than the G6 or other similar concepts, while using a reduced number of countries. In summary, the EAGLEs group is the group of emerging markets that is already relevant and is expected to gain even more prominence in this decade.

This article was published in BBVA Research’s ‘Global Economic Outlook – First Quarter 2011’ on February 8, 2011. See http://www.bbvaresearch.com for details.