Hot in the South

Authors: Uri Dadush, Bennett Stancil
Originally published by the Carnegie Endowment for International Peace

As emerging economies outpace advanced ones and policy remains expansionary in both groups, the risk of overheating is building. For now, the symptoms of overheating appear confined to a few countries, such as Brazil and Indonesia. But the global recovery is still young and the temperature is bound to rise further. Policy makers must act soon to preempt another boom-bust episode—this time in emerging markets.

What is overheating?

“Overheating” manifests itself in one of three forms: domestic imbalances, most clearly indicated by rising prices of goods and services; financial asset bubbles, which occur when asset prices soar out of line with fundamentals; and external imbalances, particularly wide and unsustainable current account deficits.

The absence of one of these three forms does not imply an economy is safe from overheating—a principle the United States ignored before the financial crisis, when low inflation encouraged policy makers to largely disregard the price bubble forming in the housing market and the unprecedented and sustained widening of the current account deficit. Policy makers must monitor all three forms effectively.

At the same time, rapid growth does not by itself indicate overheating. As presently seen in many developing economies, rapid growth can reflect sustainable improvements in overall productivity resulting from industrialization, urbanization, and high saving and investment. According to the Growth Commission, for example, thirteen countries maintained growth in excess of seven percent a year for at least thirty years in the post-war period.

Conditions for overheating are in place

Today’s global environment is uniquely conducive to overheating, however. In some respects, the situation is reminiscent of—or even more extreme than—the run-up to the 1990s Asian financial crisis:

• Growth Gap: In the five years preceding the Asian crisis, average growth in the countries at the epicenter (Hong Kong, Indonesia, Korea, Malaysia, the Philippines, and Thailand) was 4.1 percentage points higher than that in advanced countries. In 2010, the average gap between growth in G20 emerging markets¹ (referred to as “emerging markets” for the remainder of this brief) and that in advanced countries was also more than 4 percentage points. The IMF expects this annual gap to persist through 2015, with emerging markets accounting for 60 percent of global growth during this period, compared to an average of only 37 percent in the twenty-five years before the crisis.
• Interest Rates in Advanced Countries: In 1996—the year before the outbreak of the Asian crisis—the average GDP-weighted interest rate in the United States, Japan, the UK, and Germany was 3.6 percent. Today, that average is just 0.3 percent. In fact, the central banks that issue 96 percent of the world’s reserves are maintaining interest rates at their lowest levels ever.
• Emerging Market Ratings: S&P now considers emerging market debt to be, on average, investment grade for the first time in history. In addition, emerging market bonds are around 200 basis points above U.S. Treasuries, near the record lows reached in the run-up to the financial crisis.
• Expansionary Policies in Emerging Markets: Despite recent tightening in several countries, economic policy remains overwhelmingly expansionary: only one emerging economy (Indonesia) has raised its real policy interest rate above its 2002–2007 average. And the IMF expects cyclically adjusted fiscal balances in all of the emerging countries to be more expansionary in 2011 than they were in 2005–2007 ².

Nevertheless, the two situations also differ in important respects, making an imminent repeat of the Asian financial crisis unlikely.

• External Debt: Prior to the Asian crisis, those countries at the epicenter had an average external debt of 66 percent of GDP. In 2009, emerging economy debt averaged 25 percent of GDP.
• Reserves: Similarly, the crisis countries’ foreign exchange reserves covered only 3.5 months of imports, on average, before the Asian crisis. Today, they average more than 15 months.
• Exchange Rates: Flexible exchange rates—which can help insulate countries from international financial shocks—are far more prevalent today. Only three of the eleven G20 emerging economies—China, Russia, and Saudi Arabia—have fixed rates and they also have more reserves than any other country in the sample.

These strong fundamentals should help emerging markets resist external shocks for some time. But, given the conditions in place, no country should feel immune.

Hot pockets

A review of the state of emerging economies offers only early signs of overheating, but clear trouble spots are appearing in South America and South Asia.

Brazil is most clearly experiencing symptoms of overheating: output is nearly 10 percentage points above its ten-year pre-crisis trend, inflation is 1.5 percentage points above target and rising³, and the real effective exchange rate (REER) is an alarming 54 percent above its pre-crisis average.

Domestic imbalances are also growing in Argentina, where growth is well above the pre-crisis trend, inflation is more than 1 percentage point above target, and stock markets are up by nearly 60 percent since January 2008 (following a collapse of nearly the same magnitude through March 2009).

In India and Indonesia, GDP is about 10 percentage points above trend and inflation is more than 2 percentage points above target. Compared to pre-crisis levels, Indonesia’s real exchange rate has risen by 23 percent and, relative to the pre-crisis average, its current account balance is expected to deteriorate by 3 percent of GDP over the next five years. India is also suffering from significant currency appreciation and current account erosion.

So far, overheating symptoms in the other emerging markets appear confined to certain parts of the economy. Urban property prices are worrisome in China; Russia is battling high inflation and a rising currency, though output is more than 10 percentage points below trend and stock prices are down by nearly 40 percent since 2008; stock-market bubbles may be inflating in Korea and Mexico; and external imbalances are growing in South Africa and Turkey. Thus far, these problems appear manageable. But pockets of overheating can signal wider problems and can easily spill over into other sectors of the economy.

The biggest danger emerging economies face is not where they stand now, but where they could be headed. The global recovery follows a recession during which emerging markets saw no growth in 2009 and is only in its early stages, compared to the more than ten years of rapid demand expansion that preceded the Asian crisis. The worst effects of overheating may therefore still be some time away.

Similarly, capital flows remain $300 billion below their 2007 peak. In 2010, these flows represented only 4.8 percent of GDP, compared to nearly 9 percent in 2007 and 7 percent in the five years preceding the Asian crisis. Regional differences are pronounced, however. Flows to Asia and Latin America are already at or above their peaks, while flows to emerging Europe are still down by nearly 70 percent compared to 2007.

Policy adjustments are needed, and soon

Policy makers in emerging markets must act soon to engineer a soft landing. As a first step, fiscal adjustments are needed. Monetary tightening is also part of the solution, but leaning too heavily on interest rates will draw in more capital and add to exchange rate pressures—a particularly dangerous course for countries, such as Brazil and Indonesia, where inflows are already surging. Macro-prudential measures, such as raising reserve or collateral requirements, are designed to discourage credit creation without raising policy interest rates directly. Though these measures can help, their relatively confined scope makes them easier to circumvent and can also create distortions in capital markets that may amplify busts. Additionally, because they are targeted, such measures often run into resistance by well-organized interest groups.

In some countries a paced increase in the exchange rate is justified—particularly in China, where the exchange rate is undervalued and exchange rate appreciation would help ease inflationary pressures. However, this predominantly affects the prices of traded goods and, given the uncertainties that characterize the external environment, caution in allowing large and rapid exchange rate appreciation is understandable.

Where fiscal adjustment cannot mitigate overly rapid appreciation, capital inflow controls can provide temporary relief—though relaxing controls on capital outflows may be a better, more durable solution. The standard response to overly rapid exchange rate appreciation—reserve accumulation—is especially costly right now with reserve-currency yields so low. Adding to already excessive reserves also implies sterilizing the effect on the domestic money supply, which can create distortions in credit markets and the banking system.

Advanced economies also have a crucial role to play in preventing overheating. With fiscal room dwindling—and political appetites shrinking even faster—advanced economies have increasingly come to rely on loose monetary policy to sustain demand and reduce unemployment. Though their focus on domestic conditions is understandable, this course adds to the risks of overheating in emerging markets and of a sudden stop eventually. Specifically, if advanced countries delay fiscal adjustment and interest rate hikes for too long and inflation and speculative behavior build, they may be forced to tighten policy quickly. The result—a credit contraction, reduced risk appetite, slower growth, declining commodity prices, and capital flow reversals—is a movie we have seen many times before. Especially in emerging markets, it has no happy ending.

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1. These countries include Argentina, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, and Turkey. Though it recently graduated to “advanced” status, Korea is also included. Together, these countries represent 70 percent of the GDP and 62 percent of the exports of all developing countries.
2. Estimates of cyclically adjusted fiscal balances are available beginning in 2005.
3. Many developing countries target an inflation band rather than an exact level. For these countries, the inflation target should be considered the center of the band.