By Kishore Jethanandani
The third super-cycle led by emerging markets was the theme of the annual gabfest at the World Economic Forum this year. Standard Chartered Bank’s white paper on the subject created its intended buzz. The optimism sure suggested comfort with the latest recovery among the chief executives of the world. Emerging markets have been the engine of the latest recovery but signs of trouble are already noticeable. Agriculture, largely untouched by successive waves of economic reform, will act as a brake on growth in these economies.
The last green revolution, propelled by hybrid seeds and chemical fertilizers, has exhausted its potential. Commercialization of genetic engineering for plants is at an early stage of implementation. The supply chains for food in emerging markets are antiquated, with primitive cooling systems, and waste about half the food in transit. Farms look more like backyards. Negotiations on the Doha Round for agriculture trade have been going in circles for the last ten years.
While the recent upsurge in food inflation has been blamed on climate change and vagaries of weather, the reality is that emerging markets face a structural supply problem in agriculture which is not going away anytime soon. Demand for food is rising rapidly with growing incomes but supply is falling short. Central banks in emerging markets will have to increase interest rates to tame inflation and growth will slow down.
Fears of overheating of emerging markets economies, bubbles and speculators have re-emerged following the recovery from the 2008 crash. This time around two new piquant elements have been added to the story by quantitative easing, a misnomer for debt monetization, and a rise in food and commodity prices in emerging markets. The two are seen to be inter-related; quantitative easing is said to create excess money supply that feeds into the carry-over trade, with low interest rates and stagnating developed economies, and increases the demand for holding inventories of commodities and food in emerging markets.
Over the course of the last decade, financial markets in emerging market economies, especially emerging Asia, have matured and are less susceptible to sharp fluctuations induced by capital movements. Foreign capital inflows are offset by capital outflows from emerging markets. The outflows neutralize any excessive exchange rate appreciation, as a result of herding behavior, or increase in money supply as a result of central bank policies to sterilize reserves. The composition of foreign capital inflows has changed as the share of foreign direct investment increases. Foreign direct investments, unlike portfolio capital, are less likely to respond to short-term risks. Finally, the growth of local currency bond markets is a buffer in times when foreign capital flows back.
In the period between 2002 and 2007, Emerging Asia and Latin America had by 2007 achieved a net capital inflow (foreign capital inflows minus outflows from emerging markets) of zero while emerging Europe had a net capital inflow of 14% of GDP. Unsurprisingly, the deflation that followed the recession of 2009 was far more severe in emerging Europe than in emerging Asia or Latin America.
Additionally, the composition of capital inflows into emerging economies had changed considerably with an increasing share of foreign direct investments. While portfolio investments increased by $ 0.9 trillion between 2002 and 2007 to all emerging markets, FDI surged by $1.5 trillion. Foreign direct investments don’t fluctuate as much as portfolio capital inflows; the volatility of foreign direct investments during the last global financial crisis was 0.04-0.45 in a cross-section of Asian economies compared to 0.51-31.41 for portfolio investments.
A particularly noteworthy development was the incipient growth of the Asian corporate bond markets during the Great Recession. Corporate bond issuance in Asia increased from about $0.4 trillion dollars in the second quarter of 2009 to $0.85 trillion dollars in the fourth quarter. The pace of expansion of was particularly rapid in India, Korea and Indonesia as the cost of bonds fell below bank rates and their Governments supported bonds for the SME sector with guarantees. Over the long-run, local currency bond markets will offset the risks of reverse flows of foreign capital inflows.
The spurt in capital inflows into emerging markets, over the last two years, has raised alarms well before their volumes have recovered to their 2007 levels. At their peak in 2007, net foreign capital inflows were 10% of GDP and in 2010 they recovered to 7% of GDP. Of the $533 billion in reserves added in 2009, $391 billion accrued from current account surpluses and in 2010 the corresponding estimated figures were $832 billion and $369 billion or $463 billion of net foreign capital inflows (after deducting outflows from emerging markets). At their peak in 2007, the total reserves were $953 billion and current account surplus $436 billion with a net foreign capital inflow of $517 billion (after deducting outflows from emerging markets).
While the net foreign capital inflows (or incremental liquidity) are close to their peak in 2007, it would seem premature to be overly concerned about inflation expectations based on capital inflows data alone especially since most developed world economies are still performing well below their peak level which eases the pressure on demand for energy and commodities. A great deal of the surge in inflows into emerging markets involved the restoration of supply of trade credit after its abrupt disruption following the collapse of Lehman Brothers. To the extent trade credit helps to increase production in the export sector, it will not have an inflationary impact or raise exchange rates.
Price pressures in emerging markets, during much of 2010, remained modest due to abundant spare capacity except in some commodities and food items. Sustained pressure on metals prices was due to massive infrastructure investments in China and wheat prices had an upward bias due to supply constraints. Energy price rise was tempered due to spare capacity in oil and the shale oil revolution in the USA which allows for re-direction of LNG to other countries. There were also price surges as geo-political or weather risks disrupt the tenuous balance in supply and demand. Food prices were affected by the El Nino weather patterns, oil prices by the fire in the Gulf of Mexico and copper by flooding of mines in Chile. Metals prices are likely to keep increasing due to lags in mine development.
The management of interest rates by Central Banks in emerging markets, in an environment of intractable event-driven economic variables, is challenging and the bias is likely to remain mildly expansionist in 2011 as the demand for exports from the developed world is still relatively slack. To the extent upward price pressure is not systemic but is influenced by more transient causes such as weather patterns, geo-political shocks and sector-level fluctuations, central bankers will struggle to determine the timing for raising interest rates.
There is much greater room available in fiscal policy to offset the effects of increasing capital inflows into emerging markets without taking recourse to capital controls. Emerging markets expanded their fiscal expenditures and allowed their budgets to run higher deficits to soften the deleterious effects of the global recession. The average budget deficit in emerging markets increased from 0.7% of GDP to 4.8% of GDP between 2008 and 2009. India was an outlier with deficits much higher than the average at 7.9% and 10.2% of GDP. The contrasting rates of inflation in emerging markets and India suggest that a great deal of pressure on prices could be eased by a more restrictive fiscal policy. While the consumer price index in emerging markets increased by 3.1% in 2009, prices increased by 10.9% in India and projected increase in 2010 was 6.1% and 13.2%.
Emerging markets are better able to withstand the shocks of rapid capital movements and their recent experience belies myths perpetuated by financial disasters experienced in the past. The risks in the current environment are largely a result of potential inflationary impact of supply shortages of food and commodities exacerbated by expansionary monetary and fiscal policies. As long as growth rates are sub-par in the developed countries, fiscal and monetary policies in emerging markets will be the most important determinant of rates of inflation in the short-term. Central banks are likely to err on the side of monetary expansion as long as emerging markets don’t achieve their potential output in the commercial sector. Fiscal policies have a more political motivation and leave some leeway to lower rates of inflation.
Over the longer-run, the slow growth in agriculture will add to the complexities of fiscal and monetary management. There is no way that emerging markets can sustain their growth without major decisions to improve resource allocation efficiency in their rural sectors.
 “The financial stability implications of increased capital flows for emerging market economies”,by Dubravko Mihaljek, BIS Papers Number 44, 2007.
 Mihaljek, op cit
 Measure by coefficient of variation
 “Capital flows and Real Exchange Rates in Emerging Asian countries”, by Juthathip Jongwanich, Working Paper Series No 210, Asian Development Bank, July 2010.
 “Sovereigns, Funding and Systemic Liquidity”, Global Financial Stability Report, International Monetary Fund, October 2010
 “Capital flows to emerging market economies”, Institute of International Finance, January 24th, 2011
 “Capital flows to emerging market economies”, Institute of International Finance, Oct 12th 2008
 “The impact of the financial crisis on emerging market economies”, by Jack Boorman, Emerging Markets Forum, 2009
 “World Economic Outlook”, IMF, October 2010 and “World Economic Outlook Update, January 25th 2011.
 “Fiscal Monitor”, January 2011
 Quoted from World Economic Outlook, 2010, IMF