Emerging markets are ignoring challenge of structural reform warns ING IM’s Maarten-Jan Bakkum
Maarten-Jan Bakkum, emerging market strategist at ING IM, says the warning implicit in market reaction to US monetary policy earlier this year is still being ignored by a number of key emerging markets.
In the financial markets, disaster generally strikes unexpectedly. However, the big blow is invariably preceded by warning shots. The anxiety about the forthcoming normalisation of US monetary policy in the markets earlier this year, between May and August, can be viewed as such. It hit hard in the emerging world: capital flows swiftly dried up, currency values plunged, both bonds and stocks took a beating and, perhaps most importantly, the blind faith in emerging markets as an investment category was badly dented.
After a couple of months of strong headwind, it was clear where the vulnerabilities lay. Those countries with a large current account deficit, or where long-term strong capital inflows had boosted credit growth to extreme levels, where inflation was stubborn and where reforms had been neglected for years, was where the correction hit hardest. That is where investors most quickly lost their confidence. The most important of those countries were Brazil, India, Indonesia, Turkey, South Africa and Thailand.
The good news for this group was the lull in the storm after August. In September, the Fed decided to delay tapering its quantitative easing for a while, following which investors started believing in the emerging markets once again. Since then, things have remained reasonably calm and the problem markets have had every opportunity to rectify their vulnerability. The wake-up call was quite clear, but judging by the limited policy measures we have seen so far, evidently not yet clear enough.
Naturally, there are differences in the way individual countries reacted. Indonesia, Brazil, Turkey and, ultimately India too, have all raised their interest rates in recent months to reduce the acute risk of capital flight and fight inflation and trade deficits. This was an obvious move and may well have helped prevent major market turbulence. Unfortunately, all countries, with the possible exception of Indonesia, are still highly passive when it comes to making structural reforms. Ultimately, measures are needed to improve the investment climate and competitive position, plausible steps to tackle budget deficits, facilitating major investments in infrastructure.
Such decision-making is essential, but, at the same time, highly sensitive politically. With elections coming up next year in Indonesia, Brazil, Turkey and South Africa, it is virtually impossible to do what is necessary. So much has become clear. Meanwhile, the imbalances are growing and, therefore, also the vulnerability of these countries. There is little or no reduction in deficits on the current account, despite the lower growth. Inflation is rising further. Once the Fed starts tapering its money creation early next year, the pressure on the emerging world will grow further. The damage will ultimately be far greater than it would have been if governments had taken this year’s warning to heart.