Markets Insight: Emerging world needs a new economic model
By Dominic Rossi
Cheap currencies and export-led growth have run their course
The
recent weakness in emerging market equities is structural. The
developing world has reached a crossroads in the search for a new
economic model to replace an existing approach which, despite its
success to date, has run its course.
The
current economic model in emerging markets rose from the ashes of the
1997-98 crisis. That episode ripped bare the Washington Consensus that
had dominated emerging market economic thinking since the fall of the
Berlin Wall.
The Washington Consensus
espoused the then current liberal economic thinking – fixed or
quasi-fixed exchange rates, fiscal discipline, free trade, and round
after round of privatisations. The model brought early successes in
taming inflation, but failed in most other areas. The rapacious
behaviour of multinational organisations during privatisations, in
particular, convinced national governments that the Washington Consensus
was a dressed-up model of neo-colonialism.
It
is hardly surprising that the economic model that succeeded the
Washington Consensus would carry deeply nationalistic characteristics.
After 1997-98, one emerging country after another developed a model
framed around economic and financial self sufficiency. It consisted of
four key elements: cheap currencies, export-led growth, the accumulation
of US dollar reserves and the development of non-US dollar sources of
funding, especially via local currency debt markets.
By
these means, EM countries believed they would never again find
themselves on the hook to the US Treasury (or the International Monetary
Fund), nor for that matter would they need to inconvenience local
vested interests with “structural reform”.
This
model worked pretty well for a decade. Exports boomed, the accumulation
of US dollar reserves gave birth to a generation of sovereign wealth
funds, local currency debt markets swelled, and local vested interests
did rather well. A great deal of new wealth was created, and 2bn people
were lifted out of poverty as a new middle class emerged, giving the
model its political legitimacy.
But this approach has run its course. Cheap currencies
are no longer so cheap, and in real terms have largely recaptured their
lost purchasing power of 1997-98. Moreover, the export-led growth model
is now crippled by a developed world that is rapidly moving towards
balanced current accounts. It was good while it lasted, but the time has
come for emerging markets to think anew.
The next emerging market model needs to learn from the last two, keep what works, and move on. Emerging markets
need to commit to free-floating exchange rates, keep hold of their US
dollar reserves and continue to develop non-US dollar sources of
funding. But they should abandon the world of cheap currencies and
export-led growth.
The
current round of competitive devaluations is a particularly disturbing
policy development. Stagnation lies just around this particular corner.
After the 2008 collapse, inflationary problems returned surprisingly
quickly to the developing world in 2009-10 and emerging markets can ill
afford to embed these pressures with successive devaluations.
Instead,
emerging countries need to dust down the “structural reform” agenda
they quietly abandoned a decade ago and move to revitalise domestic
competition. Regulators need to be empowered to crack local oligopolies
that stifle competition and growth. Swathes of industries from telecommunications
to integrated utilities and beverage companies across the emerging
world are in the hands of one or maybe two operators. This can strangle
the small and medium-sized enterprises that typically generate
employment.
Fiscal
policy needs to find its way back on to the emerging market agenda.
Structural reform has given way to fiscal fine tuning over much of the
past decade. Tax reform is a priority, especially the mix between income
and consumption taxes. In some developing countries, momentum behind
pension and social security reform has flagged, despite the fact that
demographics is turning into a headwind rather than the tailwind it has
been for some time.
Finally,
governance within the corporate sector has failed across the emerging
world, even when companies are listed on developed country exchanges.
Unless governance practices improve, the inevitable consequence will be a
rise in the cost of capital for all.
The
emerging world has made progress over the past decade. Further steps in
the right direction will require a change to the economic model and
some painful decisions. Those that can take these steps will continue to
prosper; those that do not may look back at the past decade as a golden
era.
Dominic Rossi is chief investment officer, equities, at Fidelity Worldwide Investment
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