Markets continue to blindly trust central banks' magical ability

Despite economic slowdown, markets continue to have faith in central banks' magical ability to change the economies with a few words, an interest rate cut or more free money.


t is considered an article of faith by most investors that emerging markets will grow faster than developed markets and that emerging markets will produce consistent growth year after year. The poster child for this thesis is China. China has grown reliably for 37 years. Despite a few disquieting factors, most economist assume that this growth will continue for the foreseeable future. However, a new study suggests otherwise.


The study by two US economists, Lant Pritchett and former US Treasury Secretary Lawrence Summers, comes to the conclusion that growth above 6% in any country rarely lasts more than 10 years.


A prime example that I used in my book ‘Investing in Emerging Markets’, is Brazil. For thirteen years between 1967 and 1980, Brazil’s average annual rate of growth was 5.2%. After 1980, Brazil’s per capita income growth was flat at zero for 22 years until 2002.


Basically what the study shows is that the median period of rapid growth is nine years. After the period of rapid growth, the median drop is 4.65%. This seems astonishing given that China has grown longer and faster than any other country. The only ones that come close are Taiwan and South Korea, which grew 32 and 29 years respectively.


It appears that time is up. There is no statistical basis to show that rapid growth in the past continues into the future. A few years ago, the big story was decoupling, as emerging market growth outpaced developed countries. But even after years of free money, emerging markets are all beginning to slow. Some of their present problems are self-inflicted. Countries like Russia and Venezuela could have avoided much of the slow down with better or at least sane government policies. Other problems are more widely spread.


One of the first has to do with the commodities slow down. Many emerging markets are dependent on commodities exports. The high prices of the last few years have been exceptionally important to their growth. The countries most harmed by the decline in commodities prices include Malaysia, Indonesia, Russia, Brazil, Columbia, Chile and any country that exports oil. There are some winners including India, the Philippines, Thailand and Turkey.


One of the biggest drivers of emerging market economies recently was the growth of a consumer culture. As millions have been lifted out of poverty, they have finally been able to purchase many consumer products long since considered necessities in the developed world. However, this growth has been slowing since 2010. It has been kept artificially alive by relatively cheap credit in places like Brazil and Korea, but the consumer credit may lead to a massive credit hangover. Many people in emerging markets had access to credit and credit cards for the first time. It is not surprising that many may have misused it. It is especially bad in places like Russia where interest rates have been raised sharply to defend the currency.


Then there is China. China’s growth has been truly spectacular by any measure, but the debt amassed in the last five years is also impressive. The headlines just this week tell of major issues. Bad loans rose to their highest level in more than nine years during the third quarter. Growth in investment, factory production, exports and retail sales all slowed in October. The economy grew by an impressive 7.3% year-over-year in the third quarter, but that was its slowest pace in more than five years. New lending was also down sharply. New bank loans were only about 70% of their normal rate. Total loans were two thirds of the September rate. According to rating credit agency Standard and Poor’s, half of all Chinese provinces deserve junk ratings. Finally, some 32% of all new credit is used to pay off the interest on existing debt.


All of this news is bad for China, but it is also bad for most of the emerging markets whose main trading partner is China. As long as China slows, commodity prices will continue to fall creating a negative cycle for a large part of the world.


The final problem is that during the boom years, few countries took advantage of the favourable conditions to enact necessary reforms. Many of these reforms like inefficient labour markets and ineffective, unfair subsidies may in the short-term cause disruptions. With the economies slowing, fewer governments will take the risk to enact unpopular policies. What Pritchett and Summers refer to as “institutional inadequacies” insure that rapid growth will be unsustainable.


Meanwhile, despite the slowdown, markets continue to have faith in central banks’ magical ability to change the economies with a few words, an interest rate cut or three and scads more free money. However, like faith in the emerging market growth stories, this one will probably not have a happy ending.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)

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