Overheating in Emerging Markets: The Next Crisis?

Uri Dadush

Carnegie Endowment for International Peace

February 16, 2011

Key Points

• Conditions for overheating are in place.

• Overheating remains a largely incipient concern at present.

• But these are still early days and policy makers must take preemptive measures soon.

Growth Differential Between Advanced and Developing Countries

Source: IMF.

Average Annual GDP Growth Above Average Advanced Country GrowthPercentage Points

International Interest Rates are Much Lower than in 1996…

Central Bank Principal RatePercent

* 1996 rate reflects Bundesbank rate; current rate reflects that of the European Central Bank.Sources: Federal Reserve, Bank of Japan, Bank of England, Bundesbank, European Central Bank.

Sovereign bond spreads are down

EMBI Global Spread to U.S. TreasuriesBasis Points

…And Confidence in Developing Countries is Even Higher

Source: “Emerging Market Debt: Coming of Age”, J.P. Morgan, 2011.

Credit ratings are up

Average Emerging Market Credit Rating

Source: “Emerging Market Debt: Coming of Age”, J.P. Morgan, 2011.

…And Confidence in Developing Countries is Even Higher

However, External Debt is Much Lower…

Average External DebtPercentage of GDP

1996

2009

* Excludes Hong Kong, Korea.† Excludes Korea, Saudi Arabia.Source: World Bank.

…Reserves are Much Higher…

Average ReservesMonths of Imports

* Excludes Hong Kong.Source: World Bank.

1996

2009

…And Exchange Rates are More Flexible

Pegged FloatingHong Kong IndonesiaMalaysia KoreaThailand Philippines

Exchange Rate Regimes Prior to Asian Financial Crisis

…And Exchange Rates are More Flexible

Pegged FloatingHong Kong China Indonesia ArgentinaMalaysia Russia Korea BrazilThailand Saudi Arabia Philippines India

IndonesiaKorea

MexicoSouth Africa

Turkey

Exchange Rate Regimes Today

Note that countries with fixed exchange rate regimes have ample reserves.

Framework

Where are the Trouble Spots?

• Domestic Imbalances– Growth– Inflation

• Financial Exuberance– Stock Market

• External Imbalances– Real Exchange Rate– Current Accounts

OVERHEATING

Domestic Balances

Several countries are well above trend growth

GDP Relative to 1997-2007 TrendPercent difference

Source: IMF.

Domestic Balances

Inflation is exceeding targets in many countries

Current inflation rate above midpoint of official target bandPercentage points

* Official target unavailable. Represents current inflation rate above 10-year average rate.Source: World Bank.

Equity markets fell sharply during the crisis…

Change in Stock Index Since January 2008Percent difference

Financial Exuberance

Source: World Bank.

Financial Exuberance

…But some have rebounded well above 2008 levels

Change in Stock Index Since January 2008Percent difference

Source: World Bank.

Exchange rate appreciation has been large in some countries

Change in Real Effective Exchange Rate Relative to 1999-2008 AveragePercent change

External Balances

* Change from 2002-2008 average.Source: World Bank.

Current accounts are expected to be persistently weaker Current Account Balance

Percent of GDP

External Balances

Source: IMF.

Current accounts are expected to be persistently weaker Current Account Balance

Percent of GDP

External Balances

Source: IMF.

Overall Assessment

Clearly Overheating•Brazil•Indonesia

Possibly Overheating•India • China •Argentina

Not Overheating•Turkey • Korea •South Africa • Mexico

But Capital Flows are Much Lower and Have Yet to Truly Recover

Private Capital FlowsPercent of GDP

* Excludes Hong Kong.† G20 emerging markets account for 81 percent of major emerging market GDP.Source: World Bank, Institute of International Finance.

1996

2010

Rapid Growth Is Just Returning

Source: IMF.

Average GDP GrowthPercent

Emerging Market Domestic Policy

•Fiscal consolidation is preferred to monetary tightening.

•Earlier adjustment can allow for a soft landing.

•Foreign reserve buildup is costly.

•Relax capital outflow controls.

•Capital controls can be used as a last resort, but are not a long-term solution.

Advanced Country Policy

The starting point is bad:•Massive liquidity overhang.•Advanced countries in a fiscal mess.•Banks are still fragile.•More “Global Rebalancing” unlikely

Worst outcome for developing countries?•Inflation builds and sudden monetary tightening in major economies leads to rapid capital reversal, higher global interest rates, and slower global growth.

As recovery consolidates: •Accelerate fiscal consolidation.•Gradually tighten monetary policy.