Trouble in Emerging-Market Paradise

Nouriel Roubini

22 July 2013

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NEW YORKDuring the last few years, a lot of hype has been heaped on the BRICS (Brazil, Russia, India, China, and South Africa). With their large populations and rapid growth, these countries, so the argument goes, will soon become some of the largest economies in the world – and, in the case of China, the largest of all by as early as 2020. But the BRICS, as well as many other emerging-market economies – have recently experienced a sharp economic slowdown. So, is the honeymoon over?
Brazil’s GDP grew by only 1% last year, and may not grow by more than 2% this year, with its potential growth barely above 3%. Russia’s economy may grow by barely 2% this year, with potential growth also at around 3%, despite oil prices being around $100 a barrel. India had a couple of years of strong growth recently (11.2% in 2010 and 7.7% in 2011) but slowed to 4% in 2012.
China’s economy grew by 10% per year for the last three decades, but slowed to 7.8% last year and risks a hard landing. And South Africa grew by only 2.5% last year and may not grow faster than 2% this year.
Many other previously fast-growing emerging-market economies – for example, Turkey, Argentina, Poland, Hungary, and many in Central and Eastern Europe – are experiencing a similar slowdown. So, what is ailing the BRICS and other emerging markets?
First, most emerging-market economies were overheating in 2010-2011, with growth above potential and inflation rising and exceeding targets. Many of them thus tightened monetary policy in 2011, with consequences for growth in 2012 that have carried over into this year.
Second, the idea that emerging-market economies could fully decouple from economic weakness in advanced economies was far-fetched: recession in the eurozone, near-recession in the United Kingdom and Japan in 2011-2012, and slow economic growth in the United States were always likely to affect emerging-market performance negatively – via trade, financial links, and investor confidence. For example, the ongoing eurozone downturn has hurt Turkey and emerging-market economies in Central and Eastern Europe, owing to trade links.
Third, most BRICS and a few other emerging markets have moved toward a variant of state capitalism. This implies a slowdown in reforms that increase the private sector’s productivity and economic share, together with a greater economic role for state-owned enterprises (and for state-owned banks in the allocation of credit and savings), as well as resource nationalism, trade protectionism, import-substitution industrialization policies, and imposition of capital controls.
This approach may have worked at earlier stages of development and when the global financial crisis caused private spending to fall; but it is now distorting economic activity and depressing potential growth. Indeed, China’s slowdown reflects an economic model that is, as former Premier Wen Jiabao put it, “unstable, unbalanced, uncoordinated, and unsustainable,” and that now is adversely affecting growth in emerging Asia and in commodity-exporting emerging markets from Asia to Latin America and Africa. The risk that China will experience a hard landing in the next two years may further hurt many emerging economies.
Fourth, the commodity super-cycle that helped Brazil, Russia, South Africa, and many other commodity-exporting emerging markets may be over. Indeed, a boom would be difficult to sustain, given China’s slowdown, higher investment in energy-saving technologies, less emphasis on capital- and resource-oriented growth models around the world, and the delayed increase in supply that high prices induced.
The fifth, and most recent, factor is the US Federal Reserve’s signals that it might end its policy of quantitative easing earlier than expected, and its hints of an eventual exit from zero interest rates, both of which have caused turbulence in emerging economies’ financial markets. Even before the Fed’s signals, emerging-market equities and commodities had underperformed this year, owing to China’s slowdown. Since then, emerging-market currencies and fixed-income securities (government and corporate bonds) have taken a hit. The era of cheap or zero-interest money that led to a wall of liquidity chasing high yields and assetsequities, bonds, currencies, and commodities – in emerging markets is drawing to a close.
Finally, while many emerging-market economies tend to run current-account surpluses, a growing number of them – including Turkey, South Africa, Brazil, and India – are running deficits. And these deficits are now being financed in riskier ways: more debt than equity; more short-term debt than long-term debt; more foreign-currency debt than local-currency debt; and more financing from fickle cross-border interbank flows.
These countries share other weaknesses as well: excessive fiscal deficits, above-target inflation, and stability risk (reflected not only in the recent political turmoil in Brazil and Turkey, but also in South Africa’s labor strife and India’s political and electoral uncertainties). The need to finance the external deficit and to avoid excessive depreciation (and even higher inflation) calls for raising policy rates or keeping them on hold at high levels. But monetary tightening would weaken already-slow growth.
Thus, emerging economies with large twin deficits and other macroeconomic fragilities may experience further downward pressure on their financial markets and growth rates.
These factors explain why growth in most BRICS and many other emerging markets has slowed sharply. Some factors are cyclical, but othersstate capitalism, the risk of a hard landing in China, the end of the commodity super-cycle – are more structural. Thus, many emerging markets’ growth rates in the next decade may be lower than in the last – as may the outsize returns that investors realized from these economies’ financial assets (currencies, equities, bonds, and commodities).
Of course, some of the better-managed emerging-market economies will continue to experience rapid growth and asset outperformance. But many of the BRICS, along with some other emerging economies, may hit a thick wall, with growth and financial markets taking a serious beating.
Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank. 


Updated July 21, 2013, 8:57 p.m. ET

U.S. Growth Outlook Stuck in Neutral

GDP Expectations Dialed Back as Retailer, Restaurant Sales Falter


    The long-anticipated acceleration in the U.S. economy has been put on hold once again.
    Disappointing economic and corporate-earnings reports in recent weeks have dashed hopes that the U.S. was at last entering a phase of solid, self-sustaining growth. Instead, while economists expect a modest second-half pickup in growth, few are predicting the kind of substantial rebound needed to quickly bring down unemployment, raise wages and insulate the U.S. from economic threats abroad.
    There also are signs that consumerswhose spending has helped prop up the economy for much of the past year—are beginning to tighten their belts. Retail sales grew a paltry 0.4% in June, Commerce Department figures showed, and would have been even worse if higher gasoline prices hadn't forced drivers to spend more at the pump.

    "This year is proving to be more challenging than we had originally planned," Howard Levine, chairman and chief executive of discount retailer Family Dollar Stores Inc., told investors earlier this month. "The consumer is just more challenged than we had anticipated."

    Sales at restaurants—a key source of recent job growth, adding more than 150,000 positions over the past three monthstumbled last month, suggesting consumers could be pulling back on discretionary spending.
    The unsteady economy, both in the U.S. and internationally, is affecting companies' bottom linesresults have been mixed as firms begin reporting second-quarter earnings. Industrial giant General Electric Co. GE +4.41%reported lower global revenues but higher profit and said sales in Europe had "stabilized." Appliance maker Whirlpool Corp. WHR +7.99%posted sharply higher profits, but earnings in the technology-sector have generally fallen short of expectations.
    The Federal Reserve is watching the data closely as it decides when to begin winding down its $85 billion-a-month bond-buying program. Many Wall Street analysts expect that process to begin at the Fed's mid-September meeting.

    But in Senate testimony on Thursday, Fed Chairman Ben Bernanke said it was too early to make a decision and reiterated that the timeline will depend on how the economy performs in coming months, warning that the economy "remains vulnerable to unanticipated shocks."
    Economists now believe the economy grew at an annualized rate of just 1.5% in the second quarter, according to The Wall Street Journal's latest survey of forecasters. The economists have become markedly more pessimistic since June, when they estimated a 1.9% pace for second-quarter growth, and several forecasters now believe the growth rate fell below 1% for the second time in the past three quarters.
    Such false dawns have been a recurring theme in a recovery filled with rosy projections that last only until the next crisis or unforeseen roadblock appears. Some experts said the latest disappointments should come as little surprise: Exporters and manufacturers have been hit hard by weak overseas economies, consumers are still adjusting to tax increases that kicked in early this year, and government spending has fallen due to the "sequester" budget cuts.
    "I don't see these numbers as being surprisingly lousy," said Tara Sinclair, a George Washington University economist. "I would rather say that the forecasts we saw earlier were overly optimistic."
    Not all the news is so grim. The housing market continues to show signs of recovery despite a recent rise in mortgage rates and a slowdown in home building in June. Measures of consumer confidence have generally stayed high despite recent financial-market gyrations. And critically, the slowdown elsewhere in the economy hasn't yet led to a pullback in hiring, which has held steady at about 200,000 new jobs per month in the first six months of the year. 

    Economists aren't sure what explains the seeming disconnect between hiring and economic growth. One possibility: Employers held off on hiring amid last year's economic uncertainty and are now trying to catch up. 

    That is what happened at Fastenal Co. The Winona, Minn., seller of bolts, screws and other industrial and construction supplies was slow to hire last year, which left the company without enough salespeople, according to CEO Will Oberton.  

    Now the company is making up for lost time, hoping to hire 100 to 150 people a month for the rest of the year. 

    "We got behind on hiring people, or actually we threw the brake on a little bit," Mr. Oberton said. "We need to add the people even if the economy is slow." 

    But the hiring doesn't suggest Fastenal sees evidence of an economic rebound. "We aren't seeing any signs, or even any anecdotal stuff," Mr. Oberton said. "It seems like we've been bouncing along for quite some time."

    That kind of catch-up hiring can't continue indefinitely. At some point, either growth has to pick up or hiring will slow.

    Economists do expect modestly faster growth in the second half of the year: at a 2.4% annual rate in the third quarter and 2.7% in the fourth, according to the Journal survey. But even if those projections hold up, that would suggest another year of anemic growth around 2%, not enough to bring down unemployment quickly.

    And the projections may not hold: Ian Shepherdson, chief economist of the research firm Pantheon Macroeconomics, noted that the U.S. is expected to run up against its congressionally mandated borrowing limit sometime this fall. Another round of debt-ceiling brinkmanship, Mr. Shepherdson said, could lead small businesses in particular to pull back hiring.

    "While I think the third quarter will be better than the second, I'm nervous about the fourth," Mr. Shepherdson said.
    Others are more optimistic. Joseph LaVorgna, chief U.S. economist for Deutsche Bank in New York, pointed to several factors that suggest the economy is on firmer footing than it has been in years: stronger household balance sheets, a rebounding housing market and some early signs that state and local governments are hiring again after years of cuts.
    But Mr. LaVorgna said that after years of false starts, he doesn't blame Americans for greeting such claims with skepticism. "There is still a leap of faith," he said. "It seems like we always have an excuse or a reason to explain why the economy's weak."
    Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

    The Next Social Contract

    Kemal Derviş

    18 July 2013

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    PARISAround the world nowadays, persistent unemployment, skill mismatches, and retirement frameworks have become central to fiscal policy – and to the often-fierce political debates that surround it. The advanced countries are facing an immediateagingproblem, but most of the emerging economies are also in the midst of a demographic transition that will result in an age structure similar to that of the advanced economiesthat is, an inverted pyramid – in just two or three decades. Indeed, China will get there much sooner.
    Multiple problems affect employment. Weak demand in the aftermath of the global financial crisis that began in 2008 remains a key factor in Europe, the United States, and Japan. But longer-term structural issues are weighing down labor markets as well.
    Most important, globalization results in a continuous shift of comparative advantage, creating serious adjustment problems as employment created in new activities does not necessarily compensate for the loss of jobs in old ones. In any case, most new jobs require different skills, implying that workers losing their jobs in dying industries have little hope of finding another one.
    Moreover, technological progress is becoming ever morelabor-saving,” with computers and robots replacing human workers in settings ranging from supermarkets to automobile assembly lines. Given the volatile macroeconomic outlook, many firms are reluctant to hire new workers, leading to high youth unemployment throughout the world.
    At the same time, aging – and the associated cost of health care for the elderlyconstitutes the main fiscal challenge in maturing societies. By the middle of this century, life expectancy at age 60 will have risen by about ten years relative to the post-World War II period, when current retirement ages were fixed.
    Marginal changes to existing arrangements are unlikely to be sufficient to respond to technological forces, reduce social tensions and young people’s fears, or address growing fiscal burdens. A radical reassessment of work, skill formation, retirement, and leisure is needed, with several principles forming the core of any comprehensive reform.
    For starters, skill formation and development must become a life-long process, starting with formal schooling, but continuing through on-the-job training and intervals of full-time education at different points in life. Special youth insertion programs should become a normal part of public support for employment and career formation, with exemption from social-security contributions for the first one or two years of employment.
    A second principle is that retirement should be a gradual process. People could work an average of 1,800-2,000 hours per year until they reach their 50’s, taper off to 1,300-1,500 hours in their early 60’s, and move toward the 500-1,000 range as they approach 70. A hospital nurse, an airplane crew member, or a secondary-school teacher, for example, could work five days a week until her late fifties, four days a week until age 62, three days until age 65, and perhaps two days until age 70.
    Employers and workers should negotiate such flexibility, but they should do so with incentives and financial support from government – for example, variable social-security and income taxes. Paid holidays can be 3-4 weeks until age 45, gradually increasing to 7-8 weeks in one’s late 60’s.
    Maternity and paternity leave should be increased where it is low, such as in the United States.
    Public policies should also encourage greater scope for individual choice. For example, every ten years, a worker should be able to engage in a year of formal learning, with one-third of the cost paid by the employer, one-third by public funds, and one-third by personal savings (these proportions could vary by income bracket).
    The overall objective should be a society in which, health permitting, citizens work and pay taxes until close to the age of 70, but less intensively with advancing age and in a flexible manner that reflects individual circumstances. In fact, gradual and flexible retirement would in many cases benefit not only employers and governments, but also workers themselves, because continued occupational engagement is often a source of personal satisfaction and emotionally enriching social interaction.
    Using the Gallup World Poll, my colleagues at the Brookings Institution in Washington, DC, Carol Graham and Milena Nikolova, have found that the happiest cohorts are those who work part-time voluntarily. In exchange for longer work lives, citizens would have more time for both leisure and skill formation throughout their lives, with positive effects on productivity and life satisfaction.
    The new social contract for the first half of the twenty-first century must be one that combines fiscal realism, significant room for individual preferences, and strong social solidarity and protection against shocks stemming from personal circumstances or a volatile economy. Many countries are taking steps in this direction. They are too timid. We need a comprehensive and revolutionary reframing of education, work, retirement, and leisure time.

    Kemal Derviş, former Minister of Economic Affairs of Turkey and former Administrator for the United Nations Development Program (UNDP), is Vice President of the Brookings Institution

    July 21, 2013 8:32 pm
    Banks need far more structural reform to be safe
    Services upon which people depend should be better protected, say Michael Barr and John Vickers
    A file photo dated 01 February 2013 shows a general view of London's financial district Canary Wharf from the top of The Shard in London. The ratings agency Moody's in New York on 22 February 2013 lowered Britain's top AAA credit rating to AA1, citing a weak economy and rising debt.©EPA
    On the third anniversary of the passage of the Dodd-Frank Act, banking reform remains a work in progress across the world. In the US key provisions of the law, including the Volcker rule to limit proprietary trading, have still to be implemented and the authorities only recently published new rules on capital standards. In the EU, last month’s agreement by finance ministers on rules to govern what happens in the case of bank failures was an important step but many questions remain. And on both sides of the Atlantic, much more needs to be done on a fundamental issue – the structure of banking entities.
    This is crucial for three reasons.

    First, having a clear sense of who is in charge of what is vital when it comes to management and supervision, especially in times of stress. Structural reform and “living wills” can be used to help clarify lines of authority, align business risk with organisational form and simplify structures of complex financial institutions.

    Second, structural reform can help bolsterhorizontal buffers”, which can help stop crises spreading. Limits on the activities of retail deposit banks, restrictions on transactions between retail banks and their affiliates, independent capital and caps on counterparty credit exposures can help minimise contagion. The core banking services upon which everyday economic life depends would be better protected.

    Third, paying attention to structure would help resolve companies when they get into distress. In the US, the Federal Deposit Insurance Corporation is developing a “single point of entrymodel for resolution that would allow it to wind down a complex financial conglomerate by separating it into a holding company with “resolution-readycapital and equity, and solvent subsidiaries permitted to continue to operate. Similar approaches are being pursued in Europe.

    Structural reform will make it much more likely that such resolution plans would work in a crisis. Indeed, it is hard to see how complex financial companies can be credibly resolved without prior measures of structural reform.

    But isn’t the world diverging on issues of structure, with the US, UK and the eurozone going in different directions?

    In a word, no. There is, in fact, growing convergence on structural reform.

    The US has long used the bank holding company structure to try to separate banking from other financial activities within a complex group. Recent reforms under the Dodd-Frank Act strengthened the wall between banks and other parts of a financial group, moved more dangerous derivatives activities to affiliates, and pushed proprietary trading and significant hedge fund investing outside the group entirely.

    In the UK, the House of Lords will this week debate legislation based on the recommendations of the Independent Commission on Banking, which will move Britain more towards the US approach of using bank holding companies with separate subsidiaries. The retail banking subsidiary would have more restricted activities and would be ringfenced from other units.

    Europe is considering similar reforms proposed by the Expert Group chaired by Erkki Liikanen. These proposals would separate trading and market-making from banking activities within the company. As in the US and UK proposals, bank transactions with affiliates would need to be at arm’s length and subject to quantitative caps.

    None of these approaches is perfect, or perfectly aligned, and all are evolving. Structural reform involves difficult trade-offs: introducing rigidity may decrease efficiency and increase the risks faced by individual banks, while reducing the potential harm done to the system as a whole. In response to these trade-offs, the US, UK and Liikanen approaches all accept that universal banking can be efficient but see the need for it to have structural safeguards. Further global progress on these measures – on structured universal banking – would be well warranted.

    Ringfencing by itself, of course, will not bring financial stability. We had forms of ringfencing before the crisis, as in the US, where it blinded regulators to the dangers of shadow banking. As a result, non-bank financial institutions engaged in increasingly risky activities with too little oversight and far too much leverage.

    So structural reforms need to be part of a broader change in supervision and capital requirements, including resolution procedures for large financial companies regardless of their corporate form, and much needed reforms to derivatives markets.

    Ringfencing is no excuse to avoid regulating non-bank firms and markets that can pose a risk the financial system.

    At the same time, Europe should embrace structural reform as an essential feature of banking reform. And the prospect of eurozone banking union makes this all the more important.

    The writers are the former US assistant secretary of the Treasury for financial institutions and the former chairman of the UK’s Independent Commission on Banking

    Copyright The Financial Times Limited 2013