Club class

A new study shows emerging economies are catching up

It also sheds light on some of the mysteries of economic growth

This awful year could, paradoxically, be a good one for what economists call convergence. This normally takes place when poor economies grow faster than rich ones, narrowing the income gap between them.

This year will be a bit different. Few emerging markets will grow at all—perhaps China, Egypt and Vietnam. But because advanced economies will probably retreat even faster, the gap between them will narrow. In the pandemic, like a 400m race, the laurels go to whoever slows down least.

The last time there was such a decisive growth gap between advanced and emerging economies was in 2013 (see chart 1). That was year of the “taper tantrum”, an emerging-market sell-off prompted by fears that America would slow its pace of monetary easing. It marked the end of a decade of heady emerging-market optimism best symbolised by the enthusiasm for the “brics”, an acronym coined by Goldman Sachs, which helped sell many investors on four of the most populous emerging markets: Brazil, Russia, India and China.

The idea that “backward” economies could grow faster than mature ones was first spelled out by economic historians like Alexander Gerschenkron in the 1950s and Moses Abramovitz in the 1970s. It rests on the assumption that imitation is easier than innovation and returns to investment are high where capital is scarce.

The evidence for faster growth was weak between the 1970s and the early 1990s, but has become stronger since, as Dev Patel of Harvard University, Justin Sandefur of the Centre for Global Development and Arvind Subramanian of Ashoka University have pointed out most forcefully.

In making their projections for the brics, Goldman drew on a cautious version of the thesis, called “conditional” convergence. Simply put, this says that poor countries will grow faster than rich ones, other things equal. Those other things, for Goldman, included a country’s level of education, its openness to trade, its internet penetration and ten other characteristics.

Academics have ranged even more widely.

According to Steven Durlauf of the University of Chicago, Paul Johnson of Vassar College and Jonathan Temple, a freelance economist, researchers have identified 145 plausible factors that must be accounted for. The list includes everything from inflation and foreign direct investment to religion, frosty weather and newspaper readership.

Goldman assumed that emerging economies would catch up with a productivity frontier exemplified by America. But many economies seem to converge not towards a global leader but with their neighbours or peers. Indeed, some of the best examples of convergence come from within countries or economic blocs. Poor Japanese prefectures have tended to catch up with richer ones, as have Canadian provinces, Indian states and the regions of Europe.

If the forces of convergence operate within these blocs, it is reasonable to wonder if other such groupings exist. Are there any other convergence “clubs”, rich or poor, the members of which are bunching up?

In a new book, “Global Productivity: Trends, Drivers, and Policies”, the World Bank uses an algorithm to sort through many combinations of countries, looking for groups that seem to be converging with each other. Based on the productivity performance of 97 economies since 2000, the bank identifies five clubs. The three gloomiest groups comprise fairly poor countries. A fourth contains some big ones of unfulfilled potential, such as Argentina, Brazil, Indonesia, Mexico and South Africa.

The most successful club spans all today’s advanced economies as well as 16 emerging markets, such as China, India, Malaysia, Thailand and Vietnam (see chart 2). Poorer members tend to grow faster than the rich ones, at a pace that would halve the productivity gap between them every 48 years.

What explains the centripetal forces at work? It is not proximity: the countries range from Myanmar and Canada to Finland and Chile. Many members have impressive levels of investment and trade, but so do others in the clubs below them. Higher levels of education and government effectiveness make a bigger difference, at least at the start of their catch-up phases.

Most members of the top club also do well on a measure of economic “complexity” developed by Ricardo Hausmann of Harvard and César Hidalgo of the Massachusetts Institute of Technology. Countries score highly if their exports are both eclectic and exclusive, spanning a diverse range of products that few other countries also export.

But there are exceptions. Chile is in the top club, but appears economically uncomplicated. That may be because its exports (copper, salmon, fruit) look simple but are produced, differentiated and packaged in sophisticated ways. Its round, red cherries, for example, are carefully selected for export to China as symbols of luxury.

The authors of the World Bank’s book worry that the covid-19 pandemic will inhibit investment, shorten supply chains and breed insularity, all of which could hamper convergence. But they also note some potential silver linings. Crises, for instance, can encourage structural reforms; the lack of upkeep of outdated capital during dark times can hasten its replacement with newer technologies in the recovery.

Pioneers of convergence theory understood that a country cannot fully exploit industrial advances if it clings to customary patterns of production and consumption: what Thorstein Veblen, a sociologist, called “the received scheme of use and wont”. For this reason Abramovitz believed that war and political convulsion can serve as a “ground-clearing experience opening the way for new men, new organisations and new modes of operation”.

Optimists, who pray that convergence will outlast this convulsive year, must hope that the received scheme of use and wont is one of the pandemic’s many casualties.

European banks lose appetite for commodity trade financing

ABN Amro and BNP Paribas are retreating amid a series of scandals, large losses and rising regulation

David Sheppard, Nicholas Megaw and Stephen Morris in London

 The retreat of ABN and BNP risks making the financing of raw materials more difficult at a time when the world is already reeling from coronavirus
The retreat of ABN and BNP risks making the financing of raw materials more difficult at a time when the world is already reeling from coronavirus © FT montage

Some of Europe’s biggest banks are turning their backs on the business of financing the global market in raw materials, amid a series of scandals, large losses and increasing regulation.

This week ABN Amro announced it was exiting commodity trade financing, a business whose roots with the Dutch bank stretch back to 1824 when King William I of the Netherlands founded its predecesor to finance the East Indies colonies.

It followed last week’s news of a decision by BNP Paribas to pull back from financing the sector amid questions over the future of its Geneva-based branch, which had played a key role in establishing the modern oil trading industry.

Banks lend to traders of energy, agricultural and metal commodities through facilities encompassing borrowing bases, revolving credit lines and simple letters of credit. With a single supertanker capable of hauling a cargo of crude oil valued at more than $80m — or far more when oil prices are higher — the sums involved can be substantial. The retreat of ABN and BNP risks making the financing of raw materials more difficult at a time when the global economy is already reeling from coronavirus.

Commodity traders, which operate on razor-thin margins, said they expected that less competition would naturally cause costs to rise. The largest of them believe they may be beneficiaries if smaller competitors are squeezed out.

“If more banks withdraw from the sector then everyone could face higher financing costs, especially the smaller players,” said an executive at a major commodity trading house. “It’s likely to be part of a cycle and we wouldn’t be surprised to see more exit, before stronger banks fill this space. But in the short-term less competition will be a factor.”

Chart showing falling commodities trade finance revenues

The most immediate issue has been a series of alleged frauds revealed as commodity prices slumped in March and April in the face of government measures to try and halt the spread of the pandemic.

The most high profile was Singapore-based Hin Leong Trading, one of Asia’s biggest fuel traders. A police investigation is under way after its owner admitted to $800m of undisclosed losses.

ABN has previously been criticised by analysts for taking excessive risks to make up for a lack of scale across its corporate banking division, which includes trade and commodity finance. This led to several large one-off losses, including more than €200m linked to Hin Leong.

Meanwhile BNP decided to pause lending to commodity trade houses after being hit by losses at Coex Coffee in the US, as well as GP Global Group and Phoenix Commodities in the Middle East.

Clifford Abrahams, chief financial officer at ABN, said the bank did not take on riskier customers than peers, but added that its relatively small size meant any exposure to high-profile frauds had a bigger impact.

“If you’ve got a big, diverse portfolio you can afford to absorb the occasional big loss — we are a smaller bank in that area so those losses may be more visible,” he said.

However, while larger banks may be more insulated from the risks of fraud, the entire sector is exposed to rising regulatory costs.

Under Basel IV reforms, which come into force over the next few years, banks have less leeway to determine the risk weightings attached to their corporate loan books, requiring them to have more capital to protect against losses.

ABN’s corporate and investment banking division, for example, would need to have a third more capital than under previous arrangements.

“It makes the risk/return calculations that much tougher,” Mr Abrahams said. “That’s another reason behind our decision to focus on Europe where we have clear links with our other businesses, so there’s a better chance of earning a good return.”

Commodity traders are now asking whether the exit of two high-profile European banks will spark a wider trend. 

Jean-François Lambert, a former commodity banker and founding partner of consultant Lambert Commodities, said he feared a “herd mentality” could develop.

“Banks are thinking very hard these days about their strategy,” he said. “It may not lead to complete withdrawal but some scaling back will definitely happen, so if I was a midsized trader I would be worried.”

Mr Lambert said negotiations over the renewal of existing credit facilities could become more difficult with banks demanding additional due diligence or higher fees. 

The response to ABN’s announcement, which was part of a broader review of its corporate and investment bank, highlighted why peers may be tempted to follow suit. Shares in the bank jumped 7 per cent despite reporting a second successive quarterly loss.

ABN told analysts that pulling out of trade finance would be easier than restructuring projects at other investment banks. Its balance sheet is made up of relatively simple loans, and its mainly Asia-based customers had little crossover with the rest of its businesses.

“If it will be as easy to close it down without impacting the rest of the bank as management says, why has it taken so long?” said Kian Abouhossein, an analyst at JPMorgan. “The question is not why now, but why wasn’t it done five years ago?”

He suggested the gaps left behind by banks such as ABN and BNP are likely to be filled by more local lenders in Asia or Japanese banks. “I don’t see the other Europeans jumping in,” he said. 

Baldev Bhinder, managing director at Blackstone & Gold, a specialist commodities law firm in Singapore, said there was a “big issue” with transparency and visibility at smaller commodity houses. Banks would increasingly want more information on clients than just a strong-looking set of accounts.

“They used to lend to SMEs with good balance sheets,” Mr Bhinder said. “But I think we’ve come to a stage in the process where we must accept that balance sheets might not be the full picture.”

The biggest commodity traders are not going to run out of lenders any time soon. Trafigura, a top three independent oil trader, has loan arrangements in place with 135 banks. 

But ABN was seen as one of the most prominent. It was among the bookrunners on an $8bn revolving credit facility for Vitol, the world’s largest independent oil trader, in 2019, and its US arm was joint lead on a $1.8bn facility for Swiss-based Mercuria the same year.

Mr Lambert said: “It sends a signal when a bank of this stature exits the space.”

The nuclear option

How America might wield its ultimate weapon of mass disruption

Freezing China out of the global payments system could have unthinkable consequences

President donald trump’s sabre-rattling against corporate China has had a real but, so far, limited impact on relations between the world’s two biggest economies. That could change if he decided to go all out and cut China off from the global payments system, which America controls thanks to the dollar’s status as the world’s reserve currency and lubricant of commerce.

Mr Trump has three main ways to constrain another country financially. He can refuse its banks access to chips, a New York-based clearing house through which 95% of all dollar transactions are routed. He can try to force swift, a Belgium-based messaging system which 11,000 banks worldwide use to make cross-border payments, to expel members from the offending state. And he can slap an embargo on its financial system, threatening to punish any foreign or domestic financial institution that uses dollars—as virtually all do—but continues to transact with the embargoed firms.

These tactics have been tested on Iran, North Korea, Venezuela and Myanmar—small economies with which America had few dealings. Mr Trump’s predecessor, Barack Obama, stopped short of deploying them against Russia after its invasion of Crimea in 2014. Doing so against China, with which America trades $560bn-worth of goods annually and whose four mega-banks are the world’s largest by assets, with large dollar loan books and liabilities, looks incomparably more fraught.

What would happen if Mr Trump nevertheless tried it? A huge shock wave would hit financial markets, already knocked about by the pandemic. The Chinese currency, along with those which track it, such as the Taiwanese dollar or the South Korean won, would suffer, says Claire Huang of Amundi, an asset manager. Hong Kong would run down its dollar reserves to try to support its peg with the greenback. Money would pour into gold.

In response, China would increasingly resort to its home-grown alternative to swift, called cips. It would also try to persuade America’s allies in Europe and elsewhere that Washington was behaving irresponsibly. Many would not take much convincing. cips and the yuan, currently of marginal importance in international finance and commerce, would gain in stature at America’s expense.

China would also retaliate. It could shut its markets to Western banks and firms, block them from its infrastructure projects and limit America’s access to natural resources and basic goods it controls. And it, too, has a last-ditch deterrent: selling its $1.1trn stock of American treasury bills, equivalent to 4% of the total outstanding. America’s highly liquid bond markets may prove capable of absorbing the shock.

Then again, they might not. Most observers do not consider dumping its t-bills a serious option for China, which has little interest in destabilising its system of currency reserves. But America is not the only country capable of self-harm apparently in the service of national security.

Latin America’s Triple Sudden Stop

During a global pandemic, enforcing key health measures is essential to saving lives until a vaccine can be found. That is the only way to restart economies without multiple sudden disruptions and their crippling consequences.

Eric Parrado

parrado1_Andressa AnholeteGetty Images_latinamericacoronavirusairport

WASHINGTON, DC – Few things are as terrifying for emerging economies as the sudden stop that occurs when foreign investors lose confidence, take their capital, and flee – usually triggering currency devaluations and recessions.

Latin America and the Caribbean is now facing an unprecedented triple sudden stop involving major disruptions to human mobility, trade, and capital flows. Meeting this challenge will require astute policymaking, discipline, and creativity.

The first sudden stop involves the economic paralysis stemming from the lockdowns imposed to protect public health. A mobility tracker developed by the Inter-American Development Bank for 20 Latin American and Caribbean (LAC) countries shows that between the second week of March and the third week of June, the number of people traveling more than one kilometer daily fell by levels ranging from 22% in Brazil to 48% in Chile. Many people have been unable to earn money or spend it.

Travel restrictions have also affected international businesses and tourism. According to the Latin American and Caribbean Air Transport Association, airlines operating in the region carried just 1.08 million passengers in April, down from 35.3 million the previous year.

Tourism, which accounts for one in ten jobs and an average of 18% of GDP in the smaller LAC countries, is also in a slump. It is still unclear when the sector will be able to reclaim its vital role in the region.

Trade is the second sudden stop. The region’s exports have taken a tremendous hit, and the prices for key Latin American commodities have continued to drop substantially. From the fourth quarter of 2019 to late May, oil prices have collapsed by 50%, and copper and soybeans are down 11%.

The overall decline in global demand, owing to lower consumption and deferred investment, has spread from China to the United States and Western Europe, affecting their LAC trading partners. When one factors in the numerous global supply-side problems, the outlook is grim: by the end of the year, the World Trade Organization expects Latin American exports by volume to have fallen by 13-32%.

Finally, there is the sudden stop in capital flows. By late January, four of the seven largest Latin American countries – Brazil, Chile, Colombia, and Mexico – recorded net capital inflows of $18.6 billion. By the end of March, that had reversed to $15.6 billion in net outflows, according to data from EPFR Fund Flows and Haver Analytics.

Moreover, the United Nations Conference on Trade and Development estimates that inward foreign direct investment fell by 40-55%. Meanwhile, the average country risk, as reflected in the Emerging Market Bond Index spreads, rose from 420 in early January to a peak of 1126 basis points in late April, according to data from Refinitiv, although it has since subsided to 728 basis points in August. In short, many countries in the region are seen as too risky; borrowing costs have soared, and in some cases become prohibitive.

Remittances, a key source of income for millions of Latin American households, plummeted at the beginning of the pandemic, as expatriates lost their jobs and could no longer send money home. According to data from their respective central banks, remittances in April fell by 27.9% in Honduras, 40% in El Salvador, and 20.2% in Guatemala, compared to April 2019.

Nonetheless, remittances have recovered in recent months, largely owing to unprecedented social-assistance programs, which have underpinned a historic divergence between GDP and disposable income in the United States, a host country for many LAC migrants. Nonetheless, given great uncertainty about the continued increase in disposable income, remittance inflows to the region as a whole could fall 20-30% year on year in 2020, according to IDB calculations.

Classic sudden-stop crises are characterized by a self-correcting mechanism: A reduction in capital inflows causes the real exchange rate to depreciate, resulting in an adjustment in current-account deficits, a drop in imports, more competitive exports, and an inflow of money. Such deficits are widespread throughout the LAC region today. But with a synchronized global crisis in full swing, it is hard to see how the region can export its way out of this crisis.

Indeed, with financial markets and global value chains more integrated than at any time in human history, the effects of the COVID-19 pandemic are already similar to those of the 1980s debt crisis or the Great Depression in the 1930s. It is highly likely that Latin America and the Caribbean will suffer a large recession this year, losing 8-10% of GDP, implying that the region will take more than three years to recover to pre-pandemic GDP trend levels.

The situation is further complicated by dire pre-existing conditions, including low levels of productivity and social crises. Addressing these problems will require higher health-care spending, government transfers to the poor, and loans to struggling firms. But fiscal balances and public-debt ratios have deteriorated considerably since the global financial crisis of 2008-09, making public outlays and stimulus extremely difficult.

One lesson from previous crises is that a sudden stop is not the time to turn inward. On the contrary, the region should seek greater integration through trade agreements and the removal of tariff and nontariff barriers, such as excessive customs controls.

LAC countries will also have to make cuts in public expenditure and eliminate inefficiencies that, according to a recent study by the Inter-American Development Bank, average more than 4% of GDP. Eventually, they will have to decide how to increase resiliency through capital spending that boosts productivity and spurs growth.

Governments will also have to increase taxes to improve income distribution through social safety nets and provide better public services. The good news is the region could get a big infrastructure dividend, and even small improvements in service efficiency can boost growth by 3.5 percentage points over a ten-year period.

The triple-stop danger means action must be taken on multiple fronts, even as societies learn to live with the pandemic and possible future waves. The region will emerge from this crisis poorer, more indebted, and with a greater income-distribution problem. The faster countries contain the pandemic, the sooner they can restart their economies without multiple sudden stops and their crippling consequences.

Eric Parrado is Chief Economist and General Manager of the Research Department at the Inter-American Development Bank (IDB).