Out of the traps(en)

Out of the traps

Emerging markets are up and running

After a rocky few years, emerging markets have become more mature and resilient, says Simon Cox. But along with the drama, some of their dynamism has gone

IN 1875 THE Ottoman Empire defaulted on half its foreign debt, a victim of the “first major debt crisis of the developing world”, according to one account of the mess. Its creditors, led by the Imperial Ottoman Bank, forced the empire’s grand vizier to accept a humiliating solution. Rather than wait to be repaid out of tax revenues, they won the right to collect half a dozen taxes themselves, including stamp duty and duties on alcohol. After 15 years of tax farming, the Imperial Ottoman Bank was comfortable enough to build impressive new headquarters in Istanbul, neo-orientalist in style on one side and neoclassical on the other.

Since long before the term was invented, emerging markets have provided a rich source of both peril and profit. That financial crisis in 1875 was followed by many others, including a hatful in Turkey. And like the Imperial Ottoman Bank, investors with strong stomachs have often profited the most from emerging markets at their worst. Hedge funds that bought impaired Argentine debt for roughly 20 cents on the dollar after its default in 2001 extracted a handsome settlement from its new government last year, worth perhaps ten times what they paid, according to some estimates.

The more recent history of emerging markets has also tested plenty of stomachs. Within days of Donald Trump’s election victory his populist promises raised American bond yields, sending the price of emerging-market assets the other way. Trading partners winced at his tweets threatening American companies planning to shift their production abroad. This “Trump tantrum” appeared to be the latest in a grim sequence of setbacks for emerging markets. It followed China’s botched devaluation of the yuan in 2015, the collapse in oil and iron-ore prices in 2014 and the “taper tantrum” in 2013, when mere talk of a slowdown in asset purchases by America’s Federal Reserve threw emerging markets into turmoil. The Trump tantrum came on top of political risks arising in emerging markets themselves, including Russia’s invasion of Ukraine, the Philippines’ war on drugs, a successful coup in Thailand in 2014 and a failed one in Turkey in 2016, the removal of an unpopular president in Brazil for a fiscal misdemeanour, and the survival of embattled rulers in South Africa and Malaysia.

The presidency of Mr Trump, an avowed opponent of “globalism”, has coincided with a noticeable recovery in globalisation

Strange as it may seem, though, the presidency of Mr Trump, an avowed opponent of globalism, has coincided with a recovery in globalisation. In the first half of this year the volume of emerging-market exports was 4.6% up on a year earlier, the fastest growth since 2011, according to the Netherlands Bureau for Economic Policy Analysis, a government agency. The growing demand for semiconductor chips and sensors lifted South Korea’s and Malaysia’s electronics exports; the recovery of the oil price bolstered Russia; and a favourable turn in the weather benefited Brazil’s harvest of soyabeans and corn.

Higher exports have helped lift GDP. In the first half of 2017 the four biggest emerging economies (Brazil, Russia, India and China, known as the BRICs) all grew simultaneously for the first time in three years. Emerging-market growth still cannot match that in the miracle years of 2003-06, but it has been equally broad. So far 21 of the 24 countries in the MSCI emerging-markets index, the most popular stockmarket benchmark, have reported GDP figures for the second quarter of this year, and all of them were up on the previous quarter. Not since 2009 has growth been positive in every member that publishes quarter-on-quarter numbers.

This improvement in emerging-market growth has been accompanied by renewed enthusiasm for their currencies, bonds and shares (see chart). In August these countries recorded their ninth month in a row of capital inflows from portfolio investors, the longest streak since 2014, according to the Institute of International Finance. An index of emerging-market exchange rates compiled by MSCI has risen by 14% since its trough in January 2016. It has enjoyed its best 18 months since 2011. Even ill-favoured currencies such as the Russian rouble, Mexican peso and Chinese yuan have defied their doubters, strengthening against the dollar this year (see chart below).

The price of emerging markets’ “hard-currency” dollar bonds rose by over 6% in the first half of the year, according to J.P. Morgan. And bonds denominated in their own, hardening currencies did even better, rising by double digits. But nothing has been as eye-catching as their stockmarkets. The MSCI EM index rose above 1,000 in May from below 700 in January 2016, an annualised gain of about 33%.

The strength of the rally makes many old hands nervous. The history of emerging markets is full of imprudent investors as well as improvident borrowers. The delusion of those parting with their money often matches the myopia of those squandering it. In 1895, for example, a stockmarket boom prompted one big international bank to nearly triple its loans in two years. The bank’s own manager peddled South African mining shares such as the Transvaal Consolidated Land and Exploration Company. When the shares crashed, the bank suffered a run, turning to the government and its London owners for a bail-out. This reckless financial institution was none other than the Imperial Ottoman Bank that had grown rich from tax farming a few years earlier.

Pessimists can find a number of reasons to worry, some traditional, others more novel. Classic emerging-market crises often begin in Washington, DC, when the Fed raises interest rates or tightens monetary policy in other ways. So nerves will jangle if an uptick in American inflation pushes the Fed to increase rates faster than the market now expects. And for a new variation on this old theme, investors can fret about the Fed’s recent decision to begin trimming the assets it bought after the global financial crisis.

The commodity cycle is another time-tested source of instability. The halving of oil prices in the second half of 2014 inflicted great pain on Russia and other crude exporters. Conversely, costly oil in the years before 2014 added to the chronic trade deficits and inflation suffered by countries such as India and Pakistan. The Latin American debt crisis in 1982 was caused by a combination of a commodity shock and a Fed shock. The petrodollars earned by Gulf exporters during the oil-price spikes of the 1970s were deposited in American banks, which lent them incautiously to Latin American governments. These loans then became impossible to repay when the Fed raised interest rates sharply in 1979-81.

The have-nots

Countries not blessed with commodities have worries of their own. The only natural resource in many emerging markets is manpower, but a growth model based on labour-intensive manufacturing now faces two unaccustomed threats. One is automation. The growing versatility and user-friendliness of robotic technology may be eroding the advantages of cheap labour, resulting in what economists call “premature deindustrialisation”. Post-industrial rustbelts are common in rich economies like America. The fear is that emerging-market industries will turn rusty before their people grow rich.

Another threat is protectionism. Emerging economies have always relied on access to the world’s biggest markets for their exports. But the Trump administration is keen to reduce America’s trade imbalances, and has become more active in imposing anti-dumping duties and other tariffs on goods it considers too cheap. It has so far opened investigations into 65 potential cases of dumped or subsidised products (from Chinese staples to Colombian citric acid), compared with 44 in the same period of 2016.

As some countries worry about exporting to America’s market, others worry about importing its politics. In both Brazil and Mexico, the candidates for the next presidential election include outspoken populists who draw strength from battling with Mr Trump or mirroring his provocations. Emerging markets have traditionally had a strong comparative advantage in populism. But that is another imbalance Mr Trump seems keen to correct.

This special report will examine each of these dangers in turn. It will argue that emerging economies in recent years have become more resilient, albeit less vigorous, losing some drama as well as some dynamism. That should allow their recovery to continue despite the threats they face.

A lot of emerging-market investors are “waiting for the good old-fashioned crisis”, said Mark Dow, a money manager and former IMF economist, in a podcast interview late last year. In their experience, “it always ends with a blow-up…it’s happened so many times for so many of the old wizened EM hands that they are conditioned to believe it has to be like that again.”

It does not, but plenty of doubters remain. In particular, the failure of emerging markets to deal effectively with earlier shocks (such as higher oil prices in the 1970s, tighter Fed policy in 1979-81 and mightier Chinese manufacturing in the 2000s) has contributed to a lingering concern that middle-income countries are more likely to become “trapped” as they develop, marooned somewhere between poverty and prosperity.

If the “middle-income trap” were found to be real, it would pose a more serious problem than ever before. Countries at that intermediate level of development account for a growing share of the world’s GDP and its people. The global economy could not prosper if such an enormous part of its population and production were to become thus ensnared. Fortunately, as this report will argue, the trap is a myth.


What’s in a name?

A self-fulfilling prophecy

WHAT COUNTS AS an emerging market? Broadly speaking, an economy that is not too rich, not too poor and not too closed to foreign capital. The term was coined by Antoine van Agtmael in 1981 when he was working for the International Finance Corporation (IFC), a division of the World Bank. He hoped to create what he had named: a set of promising stockmarkets, lifted from obscurity, thereby attracting the investment they needed to thrive.

At the time, it was hard work even to compare the performance of stockmarkets in places like Brazil, India and South Korea. The IFC, having collected data on ten such markets, felt that foreign investors might take to these boondock bourses, but would be put off by the risk of investing in a single company or the trouble of diversifying across many firms and places. The answer, the IFC concluded, was to provide them with a one-stop, broadly representative “Third-World Equity Fund”. When Mr Agtmael pitched the idea to a group of fund managers at an event hosted by Salomon Brothers, some were sceptical, other intrigued. One liked the idea but hated the name. So Mr Agtmael spent the weekend dreaming up the term “emerging markets”, with which he hoped to evoke “progress, uplift and dynamism”. That label proved wildly successful.

The first such fund, pioneered by Capital Group in 1986, included only four countries. The most popular equity benchmark, the MSCI EM index, started in 1988 with ten and now spans 24. Many people complain that the category has become an indiscriminate grab-bag, throwing together economies at utterly different stages of development, such as Taiwan and Pakistan. But the group was never all that homogeneous. The ten markets in the original MSCI index included the Philippines but also Portugal, a country seven times as rich (at market exchange rates). Indeed, the markets are now more tightly correlated than they were in the early years, according to MSCI (though less so than in the crisis years from 2008 to 2013).

The emerging-markets group has also become more prosperous and more Asian. The World Bank now classifies nine of MSCI’s 24 benchmark economies as high-income. (These economies, which include Taiwan, South Korea, Qatar, the United Arab Emirates and several members of the European Union, will not feature prominently in this special report.) Asia accounts for almost 70% of the group’s combined GDP and commands a similar weight in the equity index. From Hong Kong “I can cover 60% of the market cap within four hours’ flight,” says Sean Taylor of Deutsche Bank Asset Management.

Some countries are much more important to investors than their economic weight would suggest, thanks to their unusually deep and open stock- or debt markets. The best example is South Africa: the combined value of shares on its stockmarket is more than three times its GDP. The biggest company listed on its stockmarket is Naspers, mainly because it has a 33% stake in Tencent, a Chinese internet giant.

As well as progress, uplift and dynamism, emerging markets have traditionally featured crises, defaults and slumps. Many have been laid low by profligate governments, overstretched companies, mismatched balance-sheets, fickle foreign capital or volatile commodity prices. Such setbacks can take a toll on their long-term prospects, preventing them from graduating to the ranks of mature markets. Poor economies typically become “emerging markets” because they have grown quickly. They remain “emerging” because they have not managed to grow steadily.


Mixed-income myths

The middle-income trap has little evidence going for it

Countries that are neither rich nor poor can hold their own against rivals at both extremes

EVERY FEW YEARS Foreign Affairs, a magazine about international relations, provokes a fracas in a neighbouring discipline, international economics. In 1994 it published an essay by Paul Krugman, “The Myth of Asia’s Miracle”, which re-examined the source of the tigers’ success. Then, after the Asian financial crisis, it came up with “The Capital Myth” by Jagdish Bhagwati, which re-examined the case for free capital flows, the source of the tigers’ humiliation. In 2004 it offered “Globalisation’s Missing Middle” by Geoffrey Garrett, then at the University of California, Los Angeles. This essay is cited much less often than the other two, but in a roundabout way it has been equally influential. It argued that middle-ranked countries were in a bind, unable to compete either with the cutting-edge technology of rich nations or the cut-throat prices of poor ones. “Middle-income countries”, it said, “have not done nearly as well under globalised markets as either richer or poorer countries.”

To prove his point, Mr Garrett ranked the world’s economies by GDP per person in 1980, dividing them into three groups: top, middle and bottom. He then compared their growth by that measure over the subsequent two decades, finding that the middle-ranked economies grew more slowly than either the top or bottom ones. Three years later Homi Kharas and Indermit Gill of the World Bank cited Mr Garrett’s essay in a book about East Asia’s growth prospects. They invented the term “middle-income trap”, which subsequently took on a life of its own.

The trap can be interpreted in a variety of ways, which may be one reason why so many people believe in it. Some confuse the trap with the simple logic of catch-up growth. According to that logic, poorer countries can grow faster than richer ones because imitation is easier than innovation and because capital earns higher returns when it is scarce. By the same logic, a country’s growth will naturally slow down as the gap with the leading economies narrows and the scope for catch-up growth diminishes. All else equal, then, middle-income countries should grow more slowly than poorer ones. But Mr Garrett was making a bolder argument: that middle-income countries tend to grow more slowly than both poorer and richer economies.

The notion of a trap resonated widely with policymakers, note Messrs Kharas and Gill, especially in countries where growth had lost its lustre. Najib Razak, Malaysia’s prime minister, began talking about it in 2009. Trap-talk also spread to Vietnam’s leaders in 2009 and appeared in South Africa’s National Development Plan in 2012.

By far the most prominent trap-watcher is China, one of the few middle-income economies that is more than middle-sized. In 2015 Lou Jiwei, then China’s finance minister, said that his country had a 50% chance of falling into the trap in the next five to ten years. The same fear haunts Liu He, an influential economic adviser to Xi Jinping, China’s president. Mr Liu was one of the driving forces behind a report entitled “China 2030”, published in 2012 by his Development Research Centre (DRC) and the World Bank. The report featured a chart that has perhaps done more than any other to spread the idea of a middle-income trap (see chart). It showed that of 101 countries which counted as middle-income in 1960, only 13 had achieved high-income status by 2008. The rest spent the intervening 50 years trapped in mediocrity or worse.

Slow and queasy

The evidence in the chart and Mr Garrett’s essay was suggestive but hardly systematic. However, it was buttressed by a more rigorous pair of studies by Barry Eichengreen of the University of California, Berkeley, Donghyun Park of the Asian Development Bank and Kwanho Shin of Korea University, which reached similar conclusions. They looked for fast-growing economies that subsequently suffered sustained slowdowns (defining fast growth as at least 3.5% per person, and a slowdown as a two-percentage-point drop in growth, both averaged over seven years). Their research indicated that these slowdowns seemed to cluster at GDP levels of $11,000 and $15,000 per person (converted into dollars at purchasing-power parity).

Perhaps the most sophisticated analysis was published by Shekhar Aiyar and his colleagues at the IMF in 2013. They sought to distinguish between growth traps and the natural slowdown that any country can expect as it converges with leading economies. To do this, they first calculated an expected growth path for each country, based on its income per person as well as its human and physical capital. Second, they looked for countries that were growing faster or slower than expected, resulting in positive or negative growth gaps. Third, they looked for unusually severe and sustained slowdowns, when these growth gaps widened sharply. They found that middle-income countries were more likely to suffer such setbacks, no matter how middle income was defined.

The combined weight of this economic evidence and policymakers’ intuition is hard to ignore, and seems to justify scepticism about the growth prospects of China, Malaysia, Thailand and many other emerging economies. But neither the intuition nor the number-crunching is as convincing as it looks.

Intuitively, it seems to make sense that middle-income countries will be squeezed between higher-tech and lower-wage rivals on either side. But those rivals rely on high technology or low wages for a reason. Rich economies need advanced technologies and skills to offset high wages. Poor countries, for their part, need low wages to offset low levels of technology and skill. The obvious conclusion is that middle-income countries can and do compete with both, combining middling wages with middling levels of skill, technology and productivity.

To be sure, those average levels mask huge variations. Most economies have a mix of impressive leading firms and unsophisticated stragglers. The productivity of the top quarter of American firms is at least 4.86 times that of the bottom quarter, according to a study by Eric Bartelsman, Jonathan Haskel and Ralf Martin published by the Centre for Economic Policy Research. In developing countries the gaps are even bigger. Indeed, middle-income countries are often more accurately described as mixed-income economies.

Shaping the mix are at least four possible sources of growth in GDP per person. The first is moving workers from overmanned fields to more productive factories (structural transformation). The second is adding more capital such as machinery per worker (capital-deepening). The third is augmenting capital or labour by making it more sophisticated, perhaps by adopting techniques that a firm, industry or country has not previously embraced (technological diffusion). The final source of growth derives from advances in technology that introduce something new to the world at large (technological innovation).

Economists find it helpful to keep these sources of growth separate in their minds. The mistake is to think they remain separate between countries. In reality, in most countries several of these forces are at work simultaneously, at different paces and in varying proportions. Countries do not wait until the last surplus farm worker has left the fields to begin capital-deepening. Nor do they wait until the returns to brute capital accumulation have been exhausted before they start to increase the sophistication of their production techniques. So development does not proceed in discrete stages that require a nationwide leap from one stage to the next. It is more like a long-distance race, with a leading pack and many stragglers, in which the result is an average of everyone’s finishing times. The more stragglers in the race, the more room for improvement.

Positive splits

The statistical work by Messrs Eichengreen, Park and Shin shows that middle-income countries do suffer slowdowns. But since it looks only at countries with an income per person of over $10,000, it cannot say whether they are more vulnerable to such setbacks than poor countries. That was not a question the authors ever intended to answer. When their method is extended to countries further down the income scale, it turns out that slowdowns among poorer economies are at least as prevalent as among middle-income ones.

Countries in the middle do slow more often than rich countries, but that is partly because rich economies rarely grow fast enough (3.5% per person over seven years) to be eligible for a slowdown as the paper defines it. Nor is such a slowdown sufficient to trap an economy. Hong Kong, Singapore, South Korea and Taiwan have all endured at least one, and none of them is trapped in middle income. Growth in China’s GDP per person has also slowed, to about 7.6% over the past seven years, against more than 10% over the previous seven. That qualifies as a sharp slowdown by the authors’ definition. But China is not trapped; it is still growing faster than most countries, rich or poor.

A similar problem bedevils the paper by Mr Aiyar and his IMF colleagues. To see why, suppose a miracle economy were to grow much faster than an economist would expect, given its level of income, schooling and capital. Imagine its growth were then to moderate to a more normal pace. That might count as a severe slowdown by the authors’ definition (since the country’s highly positive growth gap has dropped to zero), even though the economy was still converging on high income at a normal pace.

Or suppose a country were rapidly to increase its investment in schooling and physical capital to avoid the middle-income trap. If the strategy were successful, it might result in steady growth. But with the method used by the IMF paper, that constant growth could nonetheless count as a severe slowdown because, other things being equal, their model expects improved education and deeper capital to raise the pace of growth, not merely shore it up.

Neither of these papers, then, proves the existence of a middle-income trap as commonly understood. Indeed, Mr Eichengreen has said that his line of research was intended to explore different questions. But what about the DRC’s and World Bank’s “killer” China 2030 chart?

Its criteria for middle income are idiosyncratic. They include any country with a GDP per person between 5.2% and 42.75% of America’s, measured at purchasing-power parity. The good news is that eight countries on the chart (including Turkey, Malaysia, Oman and Poland) have since escaped the middle-income bracket thanks to better data or further growth. Ten others, the Slovak Republic among them, have also crossed that threshold but were not included on the chart because either the data or the countries themselves did not exist in 1960.

But the chart contains a more fundamental flaw. Its criteria for middle-income are too broad to be useful. By its definition, a country with a GDP of just $590 per person (at 1990 prices) counted as middle income in 1960. That includes countries like China in the middle of its Great Famine. At the other extreme, a country with a GDP per person of $13,300 in 2008 also counted as middle income. This upper threshold for 2008 is more than 2,000% higher than the lower one for 1960. No wonder so many countries remained stuck in between them.

One of them was China. Its GDP per person increased tenfold between 1960 and 2008, despite the famine and the Cultural Revolution. But because it started that period above $590 and ended it below $13,300, it remained confined to the middle square of the China 2030 grid.

One of the World Bank staff involved in the China 2030 report has subsequently co-written a paper investigating the middle-income trap more closely. It found no “evidence for [unusual] stagnation at any particular middle-income level”. More recently, research by Xuehui Han of the Asian Development Bank and Shang-Jin Wei of Columbia, and separately by Lant Pritchett and Larry Summers of Harvard, has also cast doubt on the trap. Another Harvard economist, Robert Barro, the doyen of empirical growth studies, thinks that “this idea is a myth.” The transition from middle to upper income is certainly “challenging”, he writes. But it is no more challenging than the transition from low to middle.

Messrs Kharas and Gill are themselves agnostic about the precise definition and empirical salience of the term they invented. They introduced it “with modesty, because we had not rigorously established its prevalence”, they wrote ten years later. Since some middle-income countries have undeniably stagnated, barriers to their growth clearly exist. As Messrs Kharas and Gill see it, what matters is whether these threats take a distinctive “middle-income” form, not whether they are more common or severe than the dangers facing other economies.

Trappist agnosticism

The duo came up with the term chiefly because the economics profession seemed to offer no clear or convincing growth recipe for middle-income countries. Partly as a result, policymakers often felt caught between two stools: either they clung on to old growth strategies (such as low-end manufacturing) for too long, or they embraced sophisticated models (such as the “knowledge economy”) too soon. The middle-income trap is really a middle-income dilemma.

What about Mr Garrett’s original finding in Foreign Affairs, which helped inform the thinking of Messrs Kharas and Gill? An effort to replicate that exercise, with newer data covering the same 20 years, shows a much narrower gap between middle- and high-income growth for the period from 1980 to 2000. And that gap all but disappears if the countries are divided into three groups of equal size, rather than Mr Garrett’s somewhat arbitrary 25-45-30% split.

More importantly, middle-income countries, even by his definition, grew faster than their high-income counterparts over the two decades from 1990 to 2010, as well as from 1995 to 2015. It seems that in the 1990s and 2000s middle-income countries were quite capable of competing with cutting-edge economies. So what tripped them up in the 1980s? Part of the answer may lie with America’s Federal Reserve.


Freedom from financial fear

Emerging markets have become more resilient

But not all of them have the same room for manoeuvre

IN WALKING A middle path, between self-indulgence and self-mortification, Buddhists face great temptations. This struggle for self-control animates many of their paintings, including “Star’s Seed” by the Thai artist Thawan Duchanee. The painting depicts a muscular man with the mandibles of a rhinoceros beetle—beastly appendages that symbolise man’s base cravings. Only by shedding these cravings, Buddhists believe, can man be free from fear.

The painting hangs on a wall in the Bank of Thailand, which faces its own temptations and fears. Like any central bank, it must resist the lure of inflation. And like many of its peers in emerging markets, it lives with a fear of global financial forces beyond its control. When America’s Federal Reserve raises interest rates, when global investors lose their appetite for risk, or when multinational banks shrink their lending, emerging markets worry about the impact on their own currencies, balance-sheets and economies.

The temptations and the fears are connected. Emerging markets have traditionally struggled to keep inflation under control. For that reason, they have often tethered their exchange rates to the dollar and borrowed in hard currencies at the insistence of foreign creditors. This institutional anchoring helped them attract inflows of foreign capital, which often financed large current-account deficits. But their anchors also acted as shackles. They forced the central banks slavishly to follow the Fed’s monetary policy so as to preserve their currency’s standing against the dollar. And they left their economies vulnerable to any interruption in foreign lending and investment.

Whenever foreign capital inflows dried up, emerging markets wrestled with a painful dilemma. To appease foreign investors and defend their currencies, they could raise interest rates to punishingly high levels; but that would bankrupt many domestic companies. Or they could ease monetary policy and let their currencies drop; but that would also bankrupt any companies with dollar debts. Either way promised ruin.

Ruin duly arrived in a succession of financial crises. When the Fed raised interest rates to 20% to fight inflation in 1979-81, Latin American governments could no longer afford to service the vast dollar loans extended to them by American banks. The debt crisis that followed condemned the region to a “lost decade” which may have helped inspire the notion of a middle-income trap. Something similar happened in Mexico in 1994, when the Fed again raised rates faster than expected. And a broader wave of crises struck emerging markets from July 1997, when the Thai baht broke its peg to the dollar, to January 2002, when Argentina formally abandoned the peso’s parity with the greenback. These blows rid them of both their shackles and their anchor. Without the external discipline provided by the dollar, they had to build their own institutional defences against inflation.

Control yourself

Happily, in the subsequent struggle for macroeconomic self-control, emerging markets have proved themselves more man than beetle. Inflation, averaged across the world’s emerging and developing countries, fell from 13% in 1999 to less than 4.4% last year, according to the IMF. In the members of the MSCI emerging-markets index it is even lower. The latest average, weighted by each country’s size in the index, is only 2.6%, says Bhanu Baweja of UBS, a bank (see chart).

This self-control has brought a number of benefits. First, it has allowed emerging-market governments to sell bonds denominated in their own currencies, which has given them more fiscal room for manoeuvre. For most of the past half-century, their tax and spending policies have been stuck in a “procyclicality trap”, according to Carlos Végh, Daniel Lederman and Federico Bennett of the World Bank. Governments have raised discretionary spending during booms, to placate clamorous constituents, then cut it during busts, to appease jittery creditors.

But in more recent years the pattern has shifted. Of the big emerging economies, Chile, South Korea, Turkey, India, China, Mexico, South Africa and Malaysia have all been able to pursue countercyclical policies, on average, since the turn of the century; and since the global financial crisis that began in 2007, Peru and Colombia have joined their ranks. “The region appears to have begun to finally break the shackles of the procyclicality trap,” note Mr Végh and his team.

In addition to this fiscal flexibility, the increased macroeconomic credibility of emerging markets has won them an unaccustomed degree of monetary freedom. When the Fed tightens monetary policy, they no longer have to follow in lockstep. They can keep interest rates steady, letting their currency fall against the dollar, without worrying as much about the increased threat of inflation or the heavier weight of dollar debt. Indeed, since the Fed began to raise interest rates in December 2015, many emerging-market central banks have shifted their own rates down, not up. In 17 out of the 24 members of the MSCI emerging-markets index, the central bank’s policy rate is now the same or lower than it was before the Fed’s first hike.

But some sources of vulnerability remain. The central bank’s policy rate is not the only determinant of a country’s financial conditions. Some economists, such as Hélène Rey of the London Business School, have argued that broader financial conditions, including longer-term interest rates, credit growth and capital flows, are driven by a forceful and synchronised global financial cycle that is beyond the control of local central banks. Even when they are not constrained by a peg to the dollar, emerging markets cannot free themselves from these global forces, Ms Rey argues. Policymakers must either submit to them or repel them by erecting capital controls.

The “taper tantrum” of 2013 lent support to this fear. Governments and especially companies in emerging markets had taken advantage of worldwide monetary easing to issue large amounts of cheap debt. These lax financial conditions were, however, rudely interrupted in May 2013, when Ben Bernanke, then the Fed’s chairman, mused on an eventual slowdown in the bank’s asset purchases. That was enough to unsettle big emerging markets like Brazil, India, Indonesia, South Africa and Turkey, despite their flexible currencies. They became known as the “fragile five”.

The tantrum demonstrated that floating currencies could not insulate emerging economies entirely from global financial forces, as Ms Rey has argued. But recent research by Maurice Obstfeld, Jonathan Ostry and Mahvash Qureshi of the IMF confirms that flexible exchange rates still offer more autonomy than dollar pegs. And that autonomy is greater still in countries with narrower trade deficits, lower inflation and lower levels of debt.

The fragile five seem less delicate today than they did in 2013. In the intervening years, all of them have narrowed or eliminated their current-account deficits; all except India have benefited from an improvement in the competitiveness of their currencies; and all except Turkey have reduced inflation and credit growth. In both India and Brazil, the combined debt of households and non-financial corporations has declined as a proportion of GDP since the taper tantrum. In South Africa it began falling in 2016, and in Indonesia it has increased only slowly.

The credit growth causing most concern among emerging economies is not in the formerly fragile five but in China. Its stock of outstanding credit as a proportion of its GDP is a massive 213%. This figure, known as “total social financing” (TSF), is supposed to capture all sources of finance for households and enterprises. Economists often subtract some items from this total (such as equity financing) and add others (such as the local-government bonds that have replaced some bank loans to infrastructure ventures). But these adjustments do not greatly change the underlying story.

What is scary about the number is how quickly it has risen. Five years ago it was below 169%. The IMF has identified 43 previous cases in which a country’s ratio of credit to GDP has risen by more than 30 percentage points in five years. In 38 of them the boom ended in a financial crisis or “major” slowdown. And in two of the remaining five the crisis arrived a few years later.

Many economists worry that a similar fate awaits China. Some bearish investors are counting on it. They have bet heavily against the yuan in the belief that a financial bust in China will oblige its authorities to ease monetary policy and cheapen its currency. Such exchange-rate fluctuations are now commonplace in other emerging economies. But China is still an outlier. It allows the yuan to move each day by just 2% either side of a benchmark dollar rate it sets each morning. In August 2015 it tried both to devalue the currency modestly and to introduce more two-way flexibility in its movements, but succeeded only in creating self-fulfilling expectations of further depreciation.

For a few months China seemed caught in the same trap that ensnared other Asian emerging markets in the late 1990s. It appeared to face an invidious choice between vigorously tightening monetary policy to defend the yuan, or letting the currency fall. But China had four defences that other economies lacked. Its dollar debts were modest relative to the size of its economy; it still had a large current-account surplus, which brought in a steady stream of dollar earnings; it was sitting on a bigger stockpile of foreign-exchange reserves; and it had retained closer controls on capital outflows.

Between August 2015 and January of this year it lost over $500bn of reserves as it tried to cushion the yuan’s decline. It cracked down on what it deemed to be wasteful overseas acquisitions by Chinese firms. And it subjected requests for dollars by companies and individuals to heightened regulatory scrutiny, including a daunting increase in paperwork. Eventually it was able to quash the downward pressure on the currency. Over the first eight months of this year the yuan strengthened by over 5% against a dollar that had lost much of its upward momentum. In August, the dollar value of China’s foreign-exchange reserves increased for the seventh month in a row.

Whatever its impact on the yuan, will China’s credit boom nonetheless result in a sharp slowdown in growth? To answer this question, it helps to scrutinise why its credit-to-GDP ratio rose so quickly in the first place. During the crisis year of 2009, the ratio jumped because credit grew dramatically, thanks to China’s stimulus efforts; but since then credit growth has been slowing steadily (see chart). The ratio has nonetheless continued to rise because nominal GDP has expanded unusually slowly.

Many economists point out that the credit-intensity of China’s economy deteriorated between 2011 and 2016. It took more credit to generate a yuan of growth. The reason may be that much of this credit was spent not on newly produced assets such as buildings or machinery, but on existing assets such as land and previously constructed buildings. This kind of spending adds nothing to GDP, which measures only new production, not transfers of ownership of existing wealth.

If that credit mix could be reversed, it would help China to reduce leverage without reducing growth. The relationship between new credit and new production would improve. Fortunately, that improvement has already got under way: credit growth has slowed in recent quarters even as nominal GDP growth has picked up. In response, China’s credit-to-GDP ratio in the second quarter fell by a fraction of a percentage point. If it continues to stabilise, it will lift a big macroeconomic cloud still hanging over emerging markets—especially those that provide the raw materials for China’s growth.


Commodities

A drag, not a curse

Raw materials need not undermine the countries that export them

THE LAMP POSTS in Kliptown, South Africa, do not all stand up straight. One lists awkwardly, laden with cables carrying stolen electricity to a squatters’ settlement nearby. Many families in this suburb of Soweto, a formerly black township in greater Johannesburg, are still crammed into makeshift housing. When it is hot outside, the temperature inside is “times two”, says one resident, who shares six rooms with 20 others. And when it turns cold, the chill inside is also “times two”.

On the other side of the railway tracks the government is investing heavily in Walter Sisulu Square, where in 1955 the African National Congress (ANC) and its allies adopted the Freedom Charter, a statement of principles for a post-apartheid nation. The charter’s commitments, written in stone on a monument in the square, include demolishing slums and building well-lit suburbs. They also include transferring ownership of the mineral wealth beneath the soil to the people. The contrast between what the charter says and what the slum itself reveals tells you how broken the system is, says one squatter.

The resources beneath South Africa’s soil, including iron ore, precious metals and coal, ought to be an unmitigated blessing. Johannesburg, the city of gold, owes its existence to these riches. Its landscape is still dotted with piles of sandy residue, or “tailings”, from mining and quarrying. The industry accounts for over 20% of South Africa’s exports and employs over 450,000 people. But it also adds to the volatility of South Africa’s economy and the pugnacity of its politics.

Mining and quarrying shrank by 4.7% in 2016, then rebounded, growing by 4.3% year-on-year in the first half of 2017. This improvement partly reflects stronger growth in China, which consumes almost half of the world’s coal, 30% of its gold jewellery and over 40% of its steel. But the industry’s economic prospects remain hostage to its political fortunes.

Like any industry, mining must offer sufficiently rewarding pay and profits to attract the capital and labour it requires. Unlike other industries, however, mining tends to generate excess returns or “rents” on top of that. Bosses, workers and politicians are then tempted to squabble over the division of those rents, sometimes to the detriment of the sector as a whole. This kind of economic volatility and political bitterness are two of the more troublesome “tailings” from resource wealth, not only in South Africa but in many emerging markets. In 11 of the 24 countries in MSCI’s benchmark equity index, resource rents exceeded 5% of GDP between 2011 and 2015. That qualified them as “resource-rich”, according to the World Bank. The rents of all 24 members taken together also amounted to about 5% of their combined GDP.

Many of these resource-rich economies have gone through a twin-peaked or “M-shaped” cycle since the mid-2000s. Their commodities sector (as a proportion of GDP) peaked on the eve of the financial crisis in 2007, plunged, then rebounded between 2008 and 2011 and faltered again after 2014. The first drop reflected a collapse in demand following the global financial crisis. The second one was more complicated. A slowdown in Chinese commodity purchases played a part, especially in the case of coal and construction-related resources such as iron ore. But in the case of oil, a rise in supply (and projected supply) was more important. The boom in tight oil and shale production in America prompted OPEC, the oil exporters’ cartel, to pump more crude to defend its market share. Cheap energy, in turn, cut the cost of agricultural production and dampened demand for biofuels, leading to lower prices for grains and soyabeans.

It is not easy to cope with a commodity cycle of this magnitude, driven by a boom in demand in the world’s second-biggest economy, then a supply boom in the biggest. In the face of these global forces, emerging economies can resemble the squatter’s house in Kliptown: their economies run twice as hot when commodity markets warm up, and twice as cold when the temperature drops. But although resource-rich economies cannot entirely escape the ups and downs of global commodity cycles, they can do a lot to moderate them. By containing the upturns, they can cushion the downturns. The key to this lies not in the mining industry itself, but in a country’s central bank and finance ministry. Resource-rich economies need equally resourceful macroeconomic policies.

One of the best examples is Chile. Its fiscal rule curbs government spending when the copper price exceeds its long-term trend, as judged by an independent committee of experts. During good times, fiscal restraint makes room for mining to boom without unduly squeezing the rest of the economy. During bad times, it leaves scope for fiscal easing to offset the damage.

Chile’s fiscal benchmarks were better calibrated than the rule Russia introduced in 2008 (and overhauled in 2013). Rather than allow an independent committee to estimate the long-term oil price, Russia used a backward-looking average. According to the IMF, that resulted in a benchmark oil price of $85 a barrel in 2016 when prices had already fallen to $42.

Russia was forced to abandon its fiscal rule in 2015. By then the country’s central bank had also given up trying to defend the rouble, allowing it to fall in line with the price of crude. At the time Russia’s devaluation was humiliating. But a cheaper exchange rate can be a godsend for an oil exporter when the price of crude drops. Russia’s diminished currency kept the rouble value of oil revenues steady. And by boosting Russia’s competitiveness, it helped to offset the damage that lower oil prices inflicted on the country’s trade balance. Unemployment is now lower than it was in 2013, when oil prices were around $100 a barrel.

Having survived the M-shaped commodity cycle, resource-rich emerging markets can hope for an easier script in the years ahead. China’s growth has stopped slowing and OPEC production has stopped rising. The cartel decided in November 2016 to cut production by over 3% to 32.5m barrels per day (a decision matched by restraint from 11 other oil producers, including Russia). America, meanwhile, has become an “unwitting swing producer” of oil, in the words of the Economist Intelligence Unit, a sister company of The Economist. When crude prices drop below $45 a barrel, shale producers withdraw, pushing the price back up. When prices rise above $56, America’s nimble operators invest in new rigs, pushing the price back down. So another bout of commodity-price volatility should not scupper the emerging-market recovery.

The economic instability and political division sometimes associated with natural resources have caused some economists to think of them as a curse, not a blessing. In a seminal paper published in 1995, Jeffrey Sachs and Andrew Warner, two economists then both at Harvard, found that economies dependent on resource exports grew more slowly than others not so blessed.

But economic thinking on this issue is also prone to division and swings in sentiment. Several researchers have questioned whether the resource curse is real or just a statistical illusion. The seminal Sachs-Warner study, they say, may be marred by reverse causality: rather than resource dependence leading to slow growth, it could be the other way around. This is because the two authors calculate resource exports as a proportion of GDP, so anything that lowers GDP will mechanically increase resource dependence by their measure, creating the illusion of a causal link from resources to growth.

Economists may have missed the blessings of natural resources because they were looking in the wrong place. Oil, gold, copper and other endowments may add to the level of GDP but not its growth rate. Imagine, for example, a $100bn economy growing at 1% a year. Suppose it suddenly discovers a big platinum deposit, which yields a steady additional income of $100bn, year in, year out. That would double the country’s GDP to about $200bn, much to the benefit of its people. But it would also halve the country’s growth rate, because now half of this $200bn economy is growing at 1% and the other half not at all.

Graham Davis of the Colorado School of Mines calls this phenomenon “resource drag”. In South Africa the mining and quarrying industry has been growing more slowly than the economy as a whole since 1980, dragging down South Africa’s overall GDP growth by about 0.4 percentage points. But having both the resources and the drag is still better than having neither.

Patricio Meller of CIEPLAN, a Chilean think-tank, reckons that economists have been biased against natural resources ever since Adam Smith, who witnessed impressive advances in pin-making but comparative stasis in agriculture. Even in Smith’s day that was a mistake, says Mr Meller. After all, Britain’s industrial revolution owed a lot to coal-mining.

Mr Meller sees the natural resources in his country as a platform for technological innovation. Many of the lorries that serve Chile’s mining industry, for example, are remotely controlled by people sitting in an office in Santiago, over 1,000km away. Indeed, the combination of technologies—big data, end-to-end sensors, analytics—now being applied to advanced manufacturing could also be applied to mining and agriculture.

The application of new technologies to commodities may alleviate whatever curses natural resources can bring. But their application to manufacturing industry is raising a different fear in labour-rich emerging markets. As industrial machines become more sophisticated, will they increasingly replace industrial workers? And if fewer jobs are on offer in metal-bashing and clothes-making, who will employ them?


Premature deindustrialisation

Sew what now?

Automation is less of a threat to workers in the emerging world than it is made out to be

BANGLADESH EXPORTS 60% more ready-made garments than India, a country with over eight times its population. On the busy roads of Dhaka, Bangladesh’s capital, white vans nose through the traffic on “Emergency Export Duty”, according to the ambulance-like letters painted on their sides. The success of this quintessentially labour-intensive industry helped make Bangladesh a lower-middle-income country in 2014, according to the World Bank’s classifications.

But some think that Bangladesh’s garment industry now faces a new problem almost as grave as the traffic: the threat of automation. Robots are already common in other kinds of manufacturing, but still rare in clothes-making. Of the 1.63m industrial robots in operation worldwide in 2015 (the latest year for which figures are available), only 1,580 were in textiles, apparel and leather, says the International Federation of Robotics (IFR).

Robots find garment-making so hard because its basic materials are so soft. When fabric is picked up or put down, it loses its form, creasing, crumpling, folding and draping in unpredictable formations. That can make it hard for a robot to keep track of what it is handling and where to apply itself. It might be “easier to automate the activities of a fashion designer than to automate the people who sew clothing”, suggests Michael Chui of the McKinsey Global Institute.

Jian Dai, a robotics professor at King’s College London, once described the formidable feats of robotic dexterity required even to iron a garment, something any teenager is quite able (if not always willing) to do. It requires miniaturised infra-red sensors to find the edge of the fabric, which must then be squeezed between robotic fingertips in an “impactive grip”. The robot also has to maintain the tension and smoothness of the material and align its seams. To manage all this, Mr Dai writes, the robot needs several moving parts linked in a “multiple kinetic chain”.

One firm that is tackling similar challenges is SoftWear Automation, based in Atlanta, Georgia, 8,000 miles from Dhaka. Its Sewbot uses high-speed cameras to keep track of the fabric, vacuum nozzles to pick up and rotate pieces, and rotating balls embedded in a worktop to move the fabric along. “Our technologies enable the micro-manipulation and macro-manipulation of the fabric to mimic what a seamstress could do,” says Palaniswamy Rajan, the company’s CEO. His machines can already make simple items like pillows and bath mats on a commercial scale. Next year the company hopes to offer a T-shirt production line. It says that a single Sewbot operator will be able to produce 1,142 T-shirts in an eight-hour shift, 17 times the number a traditional garment worker could make in that time.

These intriguing advances in Atlanta reflect broader progress in robotic technology. The machines are becoming cheaper, safer, more versatile and easier to instruct, notes Mr Chui. Unlike many existing industrial robots, which are kept in cages, the latest generation are safe enough to be used in crowded workspaces. They can also be easily “programmed”, a word Mr Chui puts in quotation marks, since no coding is required.

These pieces of kit are no longer the preserve of high-income countries like Japan or Germany. Of all the industrial robots shipped in 2015, a third ended up in middle-income countries, where they were mostly used in carmaking and electronics, according to IFR. China was the world’s biggest single buyer.

The rising efficiency of robots has made economists question some of their traditional prescriptions for success in development. Work by Simon Kuznets in the 1960s and 1970s suggested that modern economic growth requires moving resources out of agriculture into industry, then out of industry into services. This arc of industrialisation is supposed to carry poor countries into prosperity before eventually turning down as sophisticated services take over.

But what if robots, not people, fill the factories? The McKinsey Global Institute calculates that it would be technically possible (if not necessarily economically sensible) to automate 67% of India’s manufacturing employment. It came up with similar figures for Indonesia and Thailand. If poor countries cannot move enough workers into industry, the benefits of productivity gains in manufacturing cannot spread widely through their economies. Their opportunities for development will be squeezed by automation’s impactive grip.

Indeed, the arc of industrialisation has already changed, according to Dani Rodrik of Harvard University. In today’s emerging economies, industry’s share of employment is peaking at a lower level than it used to do, and at an earlier point in their development. This trend towards premature deindustrialisation is “not good news for developing nations”, he notes.

But Mr Rodrik’s results are not as depressing as they seem. Asia, as he points out, has so far defied premature deindustrialisation. The same, in aggregate, is true of Sub-Saharan Africa. It is chiefly in Latin America that the arc of industrialisation has lost height and reach. This Latin deindustrialisation may reflect the gradual abandonment of “import substitution” after the 1960s, when governments lowered the tariffs protecting local alternatives to foreign industrial goods. It may also reflect the arrival of China as a manufacturing superpower in recent decades. But it probably has little to do with robots, which are no more prevalent in Latin America than elsewhere.

Some researchers have questioned whether the developing world as a whole has deindustrialised. They argue that manufacturing employment became geographically more concentrated after 1990, but no less important. Nobuya Haraguchi of the United Nations Industrial Development Organisation (UNIDO), Charles Fang Chin Cheng of the University of New South Wales and Eveline Smeets, a consultant, have painstakingly pieced together employment data on over 100 developing countries, going back to 1970. They find that the average of each country’s manufacturing-employment ratio has indeed declined since the early 1990s, as Mr Rodrik showed. But when they look at developing countries in aggregate, the share of manufacturing employment is higher than in earlier decades (see chart).

These results are not as contradictory as they seem. To see why, imagine that the world contained only two countries: Colombia and China. In Colombia, industry accounted for about 30% of employment in 1990, according to the International Labour Organisation. That fell to around 20% in 2015. For China, the opposite was true. On average, then, industry’s share remained roughly the same in both years: around 25%. But in aggregate, industry’s share increased enormously, because a tenth of China’s workforce is a much bigger number than a tenth of Colombia’s.

China’s takeover of manufacturing employment may itself have peaked. The number of Chinese working in industry started falling in 2013, and China’s share of world clothing exports has also stagnated since then. This represents a “historic opportunity” for countries like India, notes Arvind Subramanian, chief economic adviser to India’s government. Countries such as Bangladesh, Indonesia and Vietnam are seizing it, but India itself is lagging. Its handicaps are largely self-imposed. The country’s garment-makers pay high duties to import the man-made fibres that now dominate the industry. Exporters can get a refund, but the procedure is cumbersome. Perhaps it could be automated.

As things stand, regulatory barriers are far more damaging for South Asia’s garment-makers than automation. Indeed, the practical people who orchestrate supply chains for clothing retailers are somewhat sceptical about the role of robots in the industry. “There are many people who have done semi-automation. But fully automated garment factories, we have not seen any…we’re probably years away,” says Spencer Fung, chief executive of Li & Fung in Hong Kong. The company’s chairman, William Fung, agrees. E-commerce may have transformed retailing, but “the supply chain that supplies this highly digitised consumer market is actually analogue.”

Automation can speed things up, but it also adds to costs. The operator of one of SoftWear’s Sewbot lines may be 17 times as productive as a traditional garment-worker, but the typical cost of labour in the United States, even on the minimum wage, is more than 18 times as much as in Bangladesh. And that does not count the cost of the bot.

Bots for basics

SoftWear Automation itself is surprisingly measured in its claims for its technology. “There’s the perception that robots will take over and automate everything,” says Mr Rajan, the firm’s boss; but he believes the sewbots will remain in the minority even 20-30 years into the future. “I expect we’ll probably automate about 20-25% of the apparel industry,” he predicts. Robots will take care of “the high-volume basics”. But “the higher fashion, lower batch sizes are always going to be done by people.”

SoftWear Automation occasionally receives calls from Bangladeshi garment-makers, but the company serves only the American market. “If you are looking to deploy our technology because you think you can save labour costs, then it’s the wrong reason to do it,” says Mr Rajan. Instead, his company aims to minimise transport costs, reduce environmental strains and relieve acute American labour shortages. One of their principal customers supplies America’s armed forces, whose uniforms are required by law to be made within the country. This anachronistic legislation is supposed to preserve America’s industrial capacity to make the things its army needs, but “the average age of seamstresses in America is 56,” Mr Rajan points out.

For the foreseeable future, then, the Sewbot is not a threat to the abundant labour in countries like Bangladesh. Its existence owes a lot to some cutting-edge innovation and more than a little to some long-standing American protectionism. Unfortunately, more examples of such protectionism are on the way.

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