Itaú BBA - "Will emerging economies submerge, while advanced economies emerge?", by Ilan Goldfajn

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"Will emerging economies submerge, while advanced economies emerge?", by Ilan Goldfajn

February 11, 2014

The beginning of 2014 came with a warning that sounded like flight instructions: fasten your belts as the year is about to start.

The beginning of 2014 came with a warning that sounded like flight instructions: fasten your belts as the year is about to start. Investors decided to withdraw billions of dollars from investment funds in emerging economies. There are victims among the countries. Turkey saw its currency depreciate and was forced into an interest rate shock to avoid the worst. Argentina and Venezuela suffer from a shortage of dollars (among other basic things), which always indicates the end of the line for such headstrong regimes. Even the BRICs such as Russia and South Africa have suffered. What is going on? What is the basis for this aversion to emerging economies? Will it reach all developing countries? How can Brazil defend itself at present?

There is certainly a negative reaction to emerging economies at the moment. Funds are flowing from emerging countries and seeking refuge in advanced economies. There were withdrawals of at least US$ 13 billion from investment funds in emerging economies this year, with US$ 8 billion just in the last week of January. Investment funds in Latin America suffered two withdrawals of over US$ 3 billion. Higher outflows were only seen right after Federal Reserve Chairman Ben Bernanke announced that the Fed would start to normalize US monetary policy at the end of May last year.

With the outflows of capital, currencies lost value, and the dollar appreciated. In January, Turkey saw its currency depreciate by more than 5% (despite a sudden interest rate hike of 4.25bps). The Hungarian forint depreciated 6.5%. In Latin America, Colombian and Chilean pesos lost, respectively, more than 4% and 5%, which is a lot for one month. Not to mention the Argentine peso, which plummeted 18% last month, indicating a typical currency crisis.

The BRICs, previously considered the future drivers of the global economy, are now considered to be undergoing a "midlife crisis" (title of a session with finance ministers that I attended at the World Economic Forum in Davos). BRIC countries have not been spared: the Russian ruble lost 6.5% and the South African rand lost almost 6% in January. The Brazilian real was somewhat spared this year, depreciating "only" near 2% last month, after suffering considerably in 2013.  What's going on in the world?

Investors are making their way back to advanced economies. Since the financial crisis in 2008, emerging economies have become the main engine of the global economy, decoupling from the developed world. However, the roles are apparently about to reverse, with the recovery in the G7 countries - especially the US - and the slowdown in key emerging economies. Brazil, China and India, for example, retreated from the 3.7%, 9.6% and 7.3% average growth posted between 2008 and 2011, to around 2.2%, 7.7% and 3 8% in 2013, respectively.

What was seen as a solid long-term trend - global growth driven by the dynamism of emerging economies - faded in the minds of investors, who now question what comes next. It seems that the trigger for the deterioration last month was the weak activity reading in China and the crisis in its informal financial market.

Many are wondering if everything has changed: will the emerging economies now submerge, while advanced economies emerge?

I don't think so. In recent decades, advanced and emerging economies alternated positive and negative performances. Times of decoupling have been followed by period of recoupling. Nowadays, more encouraging signs are seen among the advanced economies, especially in the US, which should grow by 3% this year. But a key question is whether the recovery in the advanced economies, which still account for more than half of global demand, can revive economies in the emerging world.

In the recent past, the global "tide" was decisive. During the favorable times of the first decade of the century, avoiding big mistakes was enough for emerging economies to grow reasonably. Some countries benefited more than others, but all had positive performances. The crisis in 2009, on the other hand, hit them all, regardless of the quality of their fundamentals.

This time around, the tide should rise only moderately and lift some emerging boats, but not all: it is likely that the effects of the recovery of advanced economies on emerging economies will be mixed, and determined by the fundamentals of each country.

One concern is a possible repetition of what happened in the past decade, when US interest rates began to rise from 2004 onwards after a prolonged downturn. The movement caused turmoil in markets that, if repeated in the current environment, could counterbalance the positive momentum that the recovery in the advanced world should theoretically cause.

With the expected normalization of monetary policy and the consequent reduction in global liquidity, two factors will be key to differentiate emerging economies: the dependence on foreign savings and the good use of capital inflows.

The big challenge for Brazil is to seek a good economic performance amid a moderate growth in developed countries and an heterogeneous performance among emerging economies. In the case of Brazil, macroeconomic adjustments are needed, particularly on the fiscal front. The relatively low external debt and the size of the domestic market are positive aspects. Free trade agreements would be very welcome.

The choice and quality of economic policy will be decisive for the performance of emerging countries in the medium term. Brazil still holds tools to correct and recalibrate its economic strategy, with relatively manageable political costs. The economic policy choices to be made in the coming years will likely define the performance of Brazil until at least the end of the current decade.

Ilan Goldfajn is chief economist and partner at Itaú Unibanco.

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