Emerging Markets Have Many Tools, Few Good: A. Gary Shilling

LAGOS (Capital Markets in Africa) – The rising U.S. dollar and higher interest rates are pummelling emerging markets. Foreign investors who rode the big rally in these markets in 2016 and 2017 see little reason to stick around and are leaving en masse. This shift will probably persist since dollar-denominated obligations make up some 75 percent of the trillions of dollars in developing-economy debt.  

True, cheaper currencies versus the greenback aid developing economies by making their exports cheaper for foreign buyers, but the negative financial effects swamp this positive, especially as hot money departs. Servicing dollar debts takes more local currency and makes imported oil and the many other commodities that are priced in greenbacks more expensive. This has forced Brazil and others to provide costly subsidies.

Developing economies have various strategies — none of them pleasant — to deal with their plights. Their challenge is to spur economic growth, contain inflation and curtail foreign capital flight while controlling political and social unrest and avoiding crippling but growing global protectionism.  

1. Subsidize local business. It’s very common for emerging-market countries to protect their industries. Taiwan approved a $1.9 billion relief package in 2016 for its money-losing container-shipping firms to avoid a collapse similar to that of South Korea’s Hanjin Shipping. Often, these countries vow that once their industries get big enough to withstand global competition, they’ll end their protection, but it never seems to actually happen. China uses cheap loans for its state-owned enterprises while also demanding technology transfers — or stealing it — from Western companies. Today, 14 percent of Chinese nonfinancial company profits are due to government grants and subsidies, an obvious form of protectionism. Even among private firms, many of which have state shareholders, 11 percent of profits come from the government. Brazil requires foreign firms exploring energy deals there to include the state-owned Petrobras energy firm in any venture.  
2. Raise interest rates to keep up with the increase in U.S. rates as well as to make it less attractive for foreign money to exit and to avoid deep currency devaluations. The negative consequences of higher rates, of course, include reduced borrowing, investment and economic growth. Argentina, Indonesia and Turkey are doing so, with the Argentine central bank jacking its rate up to 40 percent. Brazil’s central bank is being pressured to raise rates by the 11 percent drop in the real this year.
3. Austerity, unpopular as it is, is an ongoing option despite its questionable record and risks of intensifying a downward spiral. Brazil’s central bank said last month that the lack of a fiscal overhaul to address a gaping budget deficit makes the country more vulnerable to volatility. Greece just approved the last big austerity program with pension benefit cuts, income tax hikes and privatization. This was required by the European Union as part of the eight-year bailout, and paves the way for Greece to re-enter the global bond market.
4. Currency manipulation and devaluation. Besides China, many other developing economies also deliberately depreciate their currencies to spur exports even if it risks higher inflation. There’s a free market for the Chinese yuan currency in Hong Kong, but Beijing intervenes there periodically to control its currency abroad. Furthermore, China is surreptitious about its currency policies and alternates between emphasizing the yuan’s rate versus the dollar and comparing it to a trade-weighted basket of 11 currencies. Either way, a falling Chinese currency forces other emerging economies to devalue their currencies to remain competitive with China.
5. Push exports by political and military means. Trump has withdrawn the U.S. from the Trans-Pacific Partnership, leading China to step into the void with the 20-nation Regional Comprehensive Economic Partnership. China is wooing other countries by eliminating TPP’s requirements for higher labour and environmental standards, discipline on government-owned corporations, strengthened intellectual property rights, and a free and open internet. China is also using military pressure to increase its influence in Asia as the U.S. retreats. That includes the military bases built on rocks in the South China Sea claimed by other countries. Not surprisingly, the Philippines is now shifting its focus from America to China.
6. Financial market interference aimed at curbing currency speculation. China did so to support its faltering stock market in mid-2014. Venezuela’s far-left President Nicolas Maduro, like his predecessor, Huge Chavez, blasts currency speculators for the country’s woes when he isn’t blaming those damn “Yanquis.” Malaysia’s government wants foreign banks operating there to stop speculating in the ringgit in offshore markets, which it says is distorting the currency’s value.
7. Capital controls, such as were imposed during the Asian financial crisis of the late 1990s. They’re back now in China, where the government worries that Chinese firms’ acquisitions abroad are a cover for getting around limits on moving money abroad. So they’re tightening restrictions.
8. Currency controls are a drastic measure since they clearly discourage foreign investors due to their uncertainty and market disruptions. These can go to ridiculous extremes, as in Venezuela where dollars are so scarce that the bolivar traded at 111,000 per dollar on the black market late last year versus the official rate of 10 per dollar. With scarce dollars, imports have dried up, forcing Venezuelans trek to Colombia to buy essentials. 

So if you still want to invest in emerging markets, I suggest focusing on those countries with stable currencies, strong current-account balances, high foreign-exchange reserves and solid economies. These include South Korea, Malaysia, Taiwan, China and Poland. Avoid the poorly managed, such as Argentina, Turkey, Brazil, Egypt, Indonesia, the Philippines and South Africa.

1. Gary Shilling, a Bloomberg View columnist, is president of A. Gary Shilling & Co., a consultancy in Springfield, New Jersey. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.”

Source: Bloomberg Business News