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 Countries in Asia, Latin America and emerging Europe are being
forced to raise interest rates sharply to stave off currency
collapses and a wholesale exodus of foreign investors. Turkey, India
and South Africa jacked up rates this week, heaping pressure on
others to follow suit.
Whether these steps will steady the currencies is unclear, but one
thing is sure — economic growth, developing countries' main trump
card over their richer peers, will take a hit.
Analysts reckon Turkey's dramatic 425 basis point rate hike could
almost halve this year's growth rate, to 1.7-1.9 percent, for
example, while the South African Reserve Bank, which raised by half
a point, cut its estimates for 2014 and 2015 growth.
Indonesia's economy last year probably grew at its slowest pace in
four years, below its long-term average of above 6 percent, after
175 bps in policy tightening since June.
Even before the latest increases in borrowing costs, developing
country growth rates were under the cosh.
Not only was the developing world's 4.7 percent growth last year
almost a full percentage point under International Monetary Fund
forecasts, its premium over growth rates in advanced countries has
shrunk to its lowest in a decade.
In Brazil and Russia, growth is running below the levels forecast
for Britain and the United States in 2014.
That is very bad news for the investment outlook, going by the
findings of a recent IMF study that examined capital flows for 150
countries between 1980 and 2011.
Net capital flows to emerging economies, estimated at as much as $7
trillion since 2005, have tended to be highest during periods when
their growth differential over developed economies is high, the
paper found.
And investment flow is also "mildly pro-cyclical" with domestic
growth rates, the paper said, meaning that as developing economies
expand, they draw more investment.
"Investors are getting what they asked central banks for — higher
interest rates. But there is no denying that there is a massive
headwind to capital flows into emerging markets," said David Hauner,
head of EEMEA fixed income strategy and economics at Bank of America
Merrill Lynch.
"Historically the two main drivers of capital flows to EM (are) the
difference between EM-DM growth... (and) real U.S. interest rates
which are starting to go up."
SUDDEN STOP?
Higher interest rates raise borrowing costs for the corporate sector
and curb credit growth and consumer demand, thus hurting companies'
profits. They also make fixed income assets less attractive.
Clearly then, bad news for bond and equity investors who, Thomson
Reuters service Lipper says, have pumped almost half a trillion
dollars into emerging assets in the past decade.
Add to that bank loans, merger and acquisition deals and direct
investments by foreign companies into manufacturing and services,
and the figure just since 2005 could be as large as $7 trillion,
Institute of International Finance data show.
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Like Hauner, Morgan Stanley analysts see the central bank moves as
broadly positive, in that they raise inflation-adjusted, or real
interest rates. That ultimately makes economies more competitive by
slowing wage growth. In the meantime though, emerging markets are
exposed to the risk of a sudden stop in capital flows, highlighting
potential ructions on credit markets, asset prices, economic growth
and also politics as a result of the rate rises.
"Will we see an orderly slowdown, or a more disorderly unwind?"
Morgan Stanley said in a note. "An orderly deceleration in growth
will also be important in keeping political uncertainty at bay with
elections ahead of us in many double-deficit countries."
India, Brazil, Turkey, Indonesia and South Africa are among key
developing countries facing elections in 2014 and which are seen as
vulnerable to the withdrawal of the Fed's cheap cash because of
their budget or current account deficits.
NOT YET IN ASSET PRICES
Equity investors found out the hard way in China that fast economic
growth doesn't equate with investment returns, enduring miserable
stock market performance for two decades even as the economy grew at
turbo-charged rates.
Slowing growth is at least partly driving heavy outflows from
emerging markets, where funds tracked by EPFR Global shed over $50
billion in 2013 and over $8 billion so far this year.
But the growth allure is yet to completely fade, with many investors
focusing on long-term positives such as demographics or low
ownership of goods such as mobile phones or cars.
The question is when will asset prices reflect the inevitable
growth-inflation hit these developing countries will take, says
Steve O'Hanlon, a fund manager at ACPI Investments.
"Markets are pricing a pretty dire situation in emerging markets
(but) is EM cheaper given potential future output? I wouldn't say so
but it's getting there," O'Hanlon said.
"When currencies stop selling off, if (governments) produce real
reforms, I will be investing in those markets. If you don't see any
reforms, the rate hikes will just destroy growth, discourage
investors and make the situation far worse."
(Additional reporting by David Gaffen in
New York and Reuters bureaus in Latin America and Asia; graphic by
Vincent Flasseur; editing by Catherine Evans)
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