The Emerging-Market Beauty Pageant
From China to Mexico, investors are increasingly looking not for deals, but strong macroeconomic policy.
In recent weeks, global markets have been riding a roller coaster of volatility, fueled by changes in the pricing of the Chinese renminbi and the end of the commodities super cycle.
According to a report by the Institute of International Finance, emerging-market equities have declined by almost 17 percent and are now trading at close to a record discount against mature equity markets. Emerging-market bonds have also suffered (though less than equities), with yields rising and sovereign spreads widening to over 450 basis points, up from 380 basis points in late April. Currencies, too, have been hit, with J.P. Morgan’s aggregate foreign exchange index for emerging markets falling around 10 percent in the same period to record low levels.
For many investors, this has raised concerns over growth prospects in emerging markets as an asset class, and non-resident investors have been pulling their money out in the last few weeks.
Indeed, emerging markets are increasingly being judged on their own merits in a sort of beauty pageant for investor funds. We’ve moved past the easier segments of the competition. One can look at the last few weeks as the beginning of the more challenging “talent” segment of the pageant, which will separate those countries that have put forward clear and sound policy frameworks from those that have relied heavily on high commodity prices and expansive monetary policy — and from those that have failed to implement other necessary reforms.
Who will receive positive marks in this segment of the competition? Let’s take a look at some of the contestants.
When it comes to contestants, India has been a fan favorite. Since the election of Narendra Modi in 2014, investors have been bullish on the prime minister’s reform agenda and the country’s growth potential. India is likely to overtake China this year as the fastest-growing, large emerging-market country. Fiscal and financial sector reforms have attracted additional foreign direct investment, improved governance, and fostered a positive environment for state-level reforms. And the central bank governor, Raghuram Rajan, has bolstered the reputation of India’s monetary policy decision-making. Although reforms have not been implemented as fast as many investors would like, the fact that India’s exchange rate has outperformed other emerging-market currencies amid recent global turbulence is proof positive that investors believe the country is now on an accelerated growth trajectory.
Mexico, too, has received consistent high marks from investors for implementing sound policies. President Enrique Peña Nieto has pushed through an impressive series of policies in his two and a half years in office, including energy, fiscal, and telecommunications reforms. With solid monetary and fiscal policy management well-entrenched, the Mexican peso has fared better than other emerging-market currencies both in the 2013 taper tantrum and the recent currency swings. Peña Nieto will need to overcome political head winds to effectively continue implementation of these reforms, but the country looks to have the right policies in place to weather the current turmoil.
Not all contestants, however, are top contenders for the crown. Some countries used to be star performers but have lost their shine, and others have continued to disappoint.
First up is China. Long the outstanding performer, it has recently lost its luster as policymakers have struggled to put in place a new growth model and to deal with past excesses — while avoiding an abrupt growth slowdown. The recent devaluation of the renminbi, introduced alongside a more market-dependent currency pricing mechanism, was couched in reform-minded language. But many investors and economists saw it as a signal of what China-watchers had come to believe for some time: that policymakers are increasingly concerned that growth is stumbling and capital is flowing out of China, especially as the currency is clearly no longer an easy one-way bet. China has the tools and resilience to avoid an ugly hard landing, but policymakers in Beijing need to learn lessons about the importance of being much more transparent about their approach and signals — and investors will need to reset their expectations for what China will be able to achieve.
Brazil was also looking like a potential winner, but it rode the commodities bubble and high growth rates without putting forward strong structural reforms — thus precipitating a deterioration in its macroeconomic policy framework. As the commodities super cycle has swung down, Brazil’s growth has plummeted, while inflation has been persistently high. In fact, Brazil’s central bank is one of the few in the world currently tightening monetary policy. Policymakers need to focus on sustaining needed fiscal and monetary adjustments to provide a more stable base for growth — but this will be hard in a weak economy amid growing political turmoil. The country has been rocked by the Petrobras scandal, which is threatening to topple President Dilma Rousseff’s presidency and is holding up reforms.
Turkey was also a favorite performer in recent years, but now faces threats on multiple fronts. Political uncertainty has risen as President Recep Tayyip Erdogan has called for new parliamentary elections on Nov. 1 after his party failed to form a coalition government this summer. And security concerns dog the country: The Islamic State threatens Turkey’s southern border, and the country is at war once again with Kurdish guerrillas. Meanwhile, Turkey’s economic performance has deteriorated due to global head winds, high inflation, a low savings rate, large external financing needs, and high levels of dollar-denominated corporate debt. Questions about the independence of the central bank have given investors concerns about whether the country’s policy response to the anticipated U.S. Federal Reserve interest rate liftoff will be adequate.
Poland has been the fastest-growing economy in Central Europe for the last six to seven years, with investors rewarding its strong policy framework and integration with Western Europe and the global economy. Recently, however, Polish policymakers have put forward proposals that signal a turn away from good policy orthodoxy — and it’s making investors concerned. What was once seen as one of the best-run economies in Europe is at a rising risk of falling out of favor.
And then we have Russia. Dependent on commodities and with long-standing structural impediments to private sector development, the country was already suffering a progressive slowdown even before its incursion into Ukraine. But with oil prices now hovering around $40 a barrel (from a high of well over $100 two years ago) and stresses arising from the conflict with Ukraine, the country has suffered from massive capital outflows (foreign investors have pulled $81 billion out of the country since the beginning of 2014). To alleviate the downturn and a deepening recession, the government committed more than 3 percent of GDP to “anti-crisis” spending programs, and the central bank has cut its policy rate three times so far this year, allowing a steep drop in the ruble. But emergency measures will not fix the deep underlying structural problems facing Russia’s economy.
Dozens of other emerging-market countries will feature in this competition for investor attention, and each will increasingly be judged based on their underlying fundamentals. Which emerging-market countries will be the winners and losers in investors’ eyes will take time to sort out, but there is no doubt that the contest for who will take home the crown will reinforce one lesson: Good policy pays off, and policy mistakes will eventually be punished.
Photo credit: Alexey Filippov/Host Photo Agency/Ria Novosti via Getty Images