Emerging Markets to Fly First?

[Update: Brad Setser comments below noting that it is not necessary for an economy with a (the) reserve currency to run a deficit. Clearly, he is right here and I stand corrected. However, as I also argue, I still think that whoever will become the new reserve currency (be it one economy or several) it will entail being able to provide net capacity through an external deficit. This is also why I think China is not the right candidate]

With the recent barrage of appaling macroeconomic data from the first quarter in the context of especially Europe, one has to wonder whether those much hailed green shoots aren't, as Hempton pointed out recently, turning into brown shoots. Personally, I think don't think we are out of the woods yet; in fact, as far as I can see we haven't even entered yet since the real question is what the new global economy will look like what level of capacity and trend growth key economies will be able to muster.

Consequently and although I am lukewarm about the idea of green shoots and second derivatives, I am more positive about the narrative presented by BlackRock Inc's Bob Doll when he points to the potential in emerging markets;

Emerging-market stocks may gain an average of 20 percent this year as they rebound faster and stronger than their peers in developed countries, said Bob Doll, vice chairman and chief investment officer for BlackRock Inc. The global economy has probably seen its worst in the past two quarters, with developing nations already starting to emerge from the recession, Doll told reporters in Singapore today.

“If in fact we have seen a bottom in markets and economies are going to recover, the emerging parts of the world will recover the most and the fastest,” Doll said. “After all, their recessions were largely unwanted inventory build-up and not the credit bust in the Western world.” The MSCI Emerging Markets Index has already gained 25 percent this year, with developing countries making up all 10 of the world’s best performers. That’s outpaced the 2.3 percent retreat in the Standard & Poor’s 500 Index.

Now, when it comes to the actual headline number presented, I would assume, for the media I won't venture an opinion. However, the general idea that emerging markets such as India, Brazil and Turkey are among those economies where growth conditions are, relatively, most favorable I am very much in agreement with. Clearly, this is not going to be one way street and as we learned from parsing the data from e.g. Mexico and Argentina it indicate how the swine flu may just have tipped over the economy in the case of the former whereas the latter also looks set to enter an actual recession. However, there are positive signs too, not least in the context of India which Edward recently put under the loop and concluded that conditions might just favor India to rise well above the rest of its peers. After looking at the data myself and from reading this, I am very much inclined to agree. So yes, I do think that emerging markets are going to fly; some of it will be based on real fundamentals and some of it will be the carry trade since in a world where some of the biggest central banks are commited to low nominal interest rates the environment for carry trades are perfect if and when volatility stays down. Just witness Deutche Bank's recommendation that investors sell Euros to buy into the Ruble and Forint (who are these people?!). Astute investors will thus always remember the story of Icarus, but the underlying current is still important here.

Apart from this I want to emphasise two points.

First I think that the points above underpin the general idea that whatever global economy which will emerge in the wake of the current crisis, it will one in which the sources of global demand, yield, and capacity will be more diverse than before. This is of course the positive spin to the fundamental question of who and where global demand will come in the future, not least to satisfy the excess savings which will emerge as more economies become dependent on exports to grow.

Secondly, I want to touch briefly on a related topic which has been dominating the debate on an on-off basis lately. Specifically, I am talking about the prospect of the Chinese Yuan as the future global reserve currency (surpassing the USD) which was given new life recently in the form of a NYT op-ed by Nouriel Roubini in which the (self)-proclaimed economic oracle predicts that we are now entering an Asian century with China as the dominating the economic power. Stefan Karlsson also moves in to steal some of Mr. Roubini's thunder dryly noting that the idea of the Yuan as global reserve currency is not new as he himself predicted it four years ago. Finally, there is Jeffrey Sachs (hat tip: Mark Thoma) who also muses on the prospect of a more diversified global monetary system with the Yuan in a dominant role. 

It is always customary to begin with the points you agree with and let me be very clear here. The days of unilaterally sponsored demand by the US and the subsequent role of the USD is over. There is just no way in which the US can rise to command the same role in the global economy as it did before the subprime crisis hailed the initial fall from grace. However, the idea that China alone will rise from the ashes of this crisis to take over from the US is a fallacy. 

In essence and all the technical issues aside of whether China will choose to issue debt denominated in RMB, whether the focus of trade credits and transactions in general will move towards a favor of RMB etc, any one candidate for reserve currency status would clearly need an open capital account and almost surely, in the present context, the stomach to run a current account deficit. So let us chew on this a bit. If China become the sole economy to "take over" from the US it would mean that China should run a rather substantial external deficit. 

Basically, there are many aspects of being a reserve currency but one surely is the ability to be a net debtor nation. It goes with the territory I would say and especially in whatever "new" global edifice we will be looking at. I think this is what Roubini is missing even if his other points of a more structural and institutional nature are true; clearly China is a force to be reckoned with, but then notice this;

China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth.

You can almost smell the carry trade and yield here. There sure looks to be a healthy cake to chew on here, but the thing is that the astute commenters above are not thinking about the fact that within the next decades China will age at an unprecedented speed (perhaps even faster than Japan!). Now, I am not sure whether or not this demographics stuff has trickled down yet but in this context it is important. Clearly, there will be growth in China and she will ascend to command a larger role, but if she opens the capital account we will have the world's biggest firework and a huge version of Latvia. I am  sorry, but if you don't factor in the demographics here you are getting nowhere.

Consequently, I think that Bretton Woods III is a lame duck in so far as it is made up of one currency to take over the USD; there is just no ONE economy out able to shoulder the load. This is what has changed now, the US (or Anglo-Saxons if you will) cannot carry us anymore. Rather I imagine that it will be a basket and although China will be an important part of that basket we also need to look at India, Brazil, Turkey, Chile and a number of other economies. If the discourse solidifies towards China as the economy to single handedly pull the global economy and stage a process of rebalancing it won't be pretty once markets start to factor in the demographic fundamentals in China.

Comments

[bsetser]

claus -- the supplier of a reserve currency doesn't have to run a current acocunt deficit. the us has recently, but the us in the 50s and 60s didn't -- nor did the uk in the nineteenth century. demand for reserve assets can be met if there are capital outflows from the supplier of the reserve currency, and some of the outflows come back in the form of inflows (i.e. the buildup of reserve assets). only if countries insist on "earned" rather than "borrowed" reserves does the supplier of reserves need to run a current account deficit.

the supplier of a reserve currency though does need to let other central banks hold it as part of their reserves -- and a country that is intentionally holding its currency below its market value might well prefer not to let other central banks speculate on its future appreciation ...

[CV]

Hi Brad,

Thanks for the comment ...

Clearly you are right in so far as the facts go, but I also think that this time, as ever, is "different".

As you note a reserve currency by definition is a non manipulated currency and one which is free floating. This seems difficult to reconcile with China for all the reasons you yourself have worked so much to pin down. Clearly, I would think then that for the Yuan to ascend in unilateral importance, it would need to appreciate significantly on a broad weighted basis.

This would mean a more balanced current account and whether it would also mean a deficit is of course debatable. My main argument however is that part of the discourse of "talking up China" is also the idea that Chinese growth becomes more balanced and this is where I think we need to factor in demographics.

Consequently, this is a discussion of capacity and also a discussion of how China can conform to all those expectations investors levy on them with respect to "pull" the global economy forward. Add to this that one very clear effect of this crisis is that many economies are now joining the ranks of "export dependent" and there is just no way in which a "new" reserve currency candidate (or candidates) will not be associated with a role as net provider of global capacity through a negative current account balance.

If we peel away this aspect of "taking over from the USD" in the current global climate, it all becomes very technical and non-sensical in my opinion with all this talk about oil and trade credits denominated in Yuan. Also, if Roubini et al. are only talking about this effect and not a general shift from US to Chinese demand when they "talk up China" I think it is all much ado about nothing.

Essentially Brad, the demographics spin to this would go something like this.

In a world where more economies, as a function of their ageing profiles, become export dependency the status as a reserve currency is closely tied together with a time preference for more consumption and investment today relative to tomorrow (i.e. an external deficit). This will then allow those dependent on exports to accumulate liabilities against this economy (or these economies). I think this is important to take aboard even if reserve currency status does not de-facto mean an external deficit. In this context I see the emergence of a diverse basket rather than a unilateral ascend of China.

Claus

[raivo pommer-www.google.ee]

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BUNDESBANK

Nach dem rasanten Absturz der deutschen Wirtschaft zum Jahresbeginn sieht die Deutsche Bundesbank erste Anzeichen für eine Abschwächung der Krise. «Die konjunkturelle Belastung der deutschen Wirtschaft dürfte im ersten Quartal 2009 den Höhepunkt erreicht haben.»

Das schreibt die Notenbank in ihrem Monatsbericht Mai. Zuletzt gebe es immer mehr Konjunktursignale, die auf ein Nachlassen des Abwärtsdrucks in der Weltwirtschaft hindeuteten. «Es scheint, dass das verloren gegangene Vertrauen allmählich zurückkehrt.»

Auch die für die Export-Nation Deutschland zuletzt schmerzhaften außenwirtschaftlichen Bremseffekte dürften nach Einschätzung der Notenbank in den kommenden Monaten nicht mehr so stark ausfallen wie im zurückliegenden Winterhalbjahr. Das erstmalige Plus bei den Industrie-Auftragseingängen im März nach einer «sechsmonatigen, ununterbrochen steilen Talfahrt» dürfe im Hinblick auf die konjunkturelle Perspektive zwar nicht überbewertet werden. «Gleichwohl gibt es damit nun auch einen ersten Lichtblick von einem "harten" vorlaufenden Indikator», urteilten die Notenbanker.

Eine «rasche und durchgreifende zyklische Besserung» der Weltwirtschaft sei aber nicht zu erwarten, weil der durch die Finanzkrise ausgelöste globale Vertrauensschock noch nicht überwunden und die Bankbilanzen nun zunehmend durch eine rezessionsbedingte Verschlechterung der Kreditqualität belastet würden. «Die aufgelegten Konjunkturprogramme zusammen mit der sehr expansiv ausgerichteten Geldpolitik und den umfangreichen Maßnahmen zur Stabilisierung der Finanzmärkte werden zudem erst mit einiger Verzögerung ihre volle Wirkung entfalten», prognostiziert die Bundesbank.

[debtor finance]

I am so glad read this comment.
Thank you.