INTERNATIONAL: Emerging markets face different risks

Analysis

The past decade has seen a significant emerging market currency adjustment. Although there is considerable variation, currency purchasing power in most economies categorised as emerging markets is well below that of mature economies. Economic theory for a long time has lacked an explanation for this phenomenon. The mechanics of the process are relatively well understood, but in practice, there remains much to discover.

Structural change. A currency's purchasing power depends on the strength of its non-tradable sectors. The process of transitioning from developing to developed economy is a structural change, in which new sectors replace traditional ones:

• In a typical emerging market, this usually sees stagnation of labour-intensive traditional sectors, while human capital-intensive sectors grow extremely strongly. Three-digit growth rates for several consecutive years are common for such newly emerging sectors.
• As a consequence, the economy's underlying sectoral structure changes. However, new sectors experiencing rapid structural change tend to be export-oriented, producing products for consumption in mature economies, which are generally too expensive for the domestic market.
• Often, large physical investment inflows in production inputs, such as machinery, counterbalance the rise in exports. Therefore, at this early phase, the currency's purchasing power usually stays at a low level (if there is a 'typical' level for this phase, it would be in the 30-50% range, relative to the dollar).
• However, revenue inflows gradually spill over into the domestic economy, creating additional demand in the non-tradable sector. Generally, this leads to increased overall domestic demand, boosting domestic prices, and thus increasing inflation.
• Strong exports usually mean that the ensuing inflation differential with trade partners (typically dominated by mature economy markets) is not translated fully into currency weakening, and thus the currency's purchasing power rises.
• Structural change accompanying these economies' 'emergence' creates a mechanism that equalises emerging market currencies' purchasing power.

Global patterns. Many new emerging markets have risen over the past 15 years. For instance, former communist countries metamorphosed into 'transition economies', which experienced very rapid structural change, thanks largely to former communist regimes' emphasis on education:

• Polish purchasing power rose from 27-60% between 1990 and the mid-2000s, while that of Germany shrank from 120-109%.
• In the same period, Hungarian currency purchasing power rose from 31-61%, while that of neighbouring Austria stayed at 112-108%.
• Romania saw a similar rapid change from 29-54% in a half a decade in the early 2000s, while Greece moved only from 72-88% in 15 years, and Italy stayed in the 117-108% range.

This experience mirrors that of Spain, Singapore and South Korea when they emerged in the 1980s. China and Turkey are more current examples:

• In recent years, both have seen substantial pressures towards real appreciation of their currencies, originating in structural change to the economy.
• This is despite China and Turkey having dramatically different records with past currency regimes, and experience of volatility.

At the same time, a host of emerging markets that either have ineffective governance and are under-performing -- or in some cases, such as India, chose a delayed approach to currency liberalisation -- have seen their currencies' purchasing power decline to even lower levels.

Crisis impact. In recent years, it has become a truism of financial analysis that performing emerging markets would see pressure on their currency to appreciate in real terms (either through domestic inflation exceeding foreign inflation, or outright currency appreciation in absolute terms). However, there is lack of consensus on how current global economic difficulty will affect currency dynamics (see INTERNATIONAL: Fiscal overhang limits dollar's rise - September 16, 2008). Emerging market volatility has increased substantially, but there is a lack of overall direction. This may reflect merely lack of consensus in thinking on global emerging markets (see INTERNATIONAL: Modelling global risks remains tenuous - September 9, 2008).

Refined differentiation? However, it is more likely that the concept of 'emerging market' has become obsolete, with need for more refined differentiation within the group. This is likely to see differentiation between 'successful' and 'risky' countries, as well as that reflecting underlying dynamics of structural change:

• EU. Countries that recently joined the EU will see no long-term halt to their currencies' adjustment to euro-area purchasing power levels. However, though this means that currencies will appreciate further in real terms in most new EU members -- Slovenia is a notable exception that made all necessary adjustments before adopting the euro -- there is still a wide range of purchasing power levels within the euro-area. With purchasing power equalisation occurring in the long run, some central European economies could see substantial setbacks in the medium term, due to under-performing economic management.
• Russia and Gulf States. Emerging markets dominated by extractive industries, such as Russia or the Gulf States, are likely to see natural resource prices determining domestic demand and currencies' purchasing power. Although these countries remain cash-rich, thanks to the recent increase in global demand for raw materials, even a relatively short lull in prices could change these currencies' trajectories (see INTERNATIONAL: OPEC resolve is uncertain - September 18, 2008).
• China and Brazil. A third large category of emerging markets only recently have seen an upsurge in domestic demand, and are large enough to withstand a relatively longer trough in global demand for their exports. China and Brazil are the most important examples: domestic dynamics make the long-term real appreciation of these currencies very likely. Short-term financial market scares are likely to grab attention even in these cases.
• Outliers. A fourth category of countries have seen some structural change, but have no buffer from guaranteed access to markets, accumulated oil revenues, or a very large domestic economy in the process of taking off. These countries' currencies (eg Mexico, Thailand, Ukraine and Indonesia) could suffer structural damage as a result of a currency crisis, with potential for long-term negative impact.