THE GLOBAL ECONOMIC ENVIRONMENT FOR EMERGING MARKETS JEFFREY FRANKEL HARPEL PROFESSOR OF CAPITAL FORMATION AND GROWTH HARVARD UNIVERSITY ANNUAL SYMPOSIUM ON CAPITAL MARKETS MEDELLIN, COLOMBIA, MAY 3, 2012

TWO - SPEED RECOVERY: EMS BOUNCED BACK FROM THE GLOBAL RECESSION MORE STRONGLY THAN ADVANCED ECONOMIES World Economic Outlook, IMF, April 2012

EM RECOVERY FROM THE GLOBAL RECESSION CONTINUES STRONGER THAN USUAL, BUT NOT SO FOR ADVANCED ECONOMIES.

SINCE LAST YEAR, THE IMF HAS REVISED 2012 GROWTH ESTIMATES DOWN SLIGHTLY, ESP. FOR EUROZONE. World Economic Outlook, IMF, April 2012

Euro-recession is pulling down growth. Emerging Market growth is slowing too, but solidly >0. The US is doing better. Rate of growth of real GDP (%), Projections for 2012 & 2013 World Economic Outlook, IMF, April 2012

FOUR BIG RISKS THREATEN THE GLOBAL OUTLOOK “Big” means, not “high probability” per year, but probability > 20% per year, with big consequences if it were to happen. 1) New € crisis => more defaults on periphery, higher spreads even in northern Europe & possible break-up of €-zone. 2) New partisan US budget stand-off. 3) Return of “risk off”; EMs hit? 4) Commodity price volatility E.g., world oil prices double again.

(1 ) THE CRISIS OF SOVEREIGN DEBT IN THE EURO PERIPHERY WILL RETURN The flash point right now is Spain. The flash point right now is Spain. The trigger in a year could be Greece, again: The trigger in a year could be Greece, again: Greece cannot get back to a sustainable debt path by austerity, as has been clear for awhile. Greece cannot get back to a sustainable debt path by austerity, as has been clear for awhile. When it eliminates its primary budget deficit, no more incentive to keep servicing debt. => default. When it eliminates its primary budget deficit, no more incentive to keep servicing debt. => default. By then Euro banks may no longer have life-threatening exposure By then Euro banks may no longer have life-threatening exposure having passed debt to ECB, EFSF…+ provisioned. having passed debt to ECB, EFSF…+ provisioned. With default, Greek exit from euro begins to make sense. With default, Greek exit from euro begins to make sense. Or Portugal or Italy. Regardless, contagion to others. Or Portugal or Italy. Regardless, contagion to others. This time it will probably hit France as well. This time it will probably hit France as well. Could contagion reach other high-debt countries? Could contagion reach other high-debt countries? UK? Japan? US? UK? Japan? US?

ACROSS ADVANCED COUNTRIES, DEBT/GDP IS ALMOST THE HIGHEST IN A CENTURY, SECOND ONLY TO WWII SPIKE

(2) US DEFICIT WOES WILL RETURN The US has mismanaged its finances as badly as Europe. The US doesn’t have the excuse of 17 legislatures, just two deadlocked political parties. It is a long-term problem: i) Future deficits in “entitlement spending” social security & Medicare. ii) Current budget deficits since 1981 Steps in 1990s to restore surplus worked, but were reversed in 2001.

THE US NATIONAL DEBT AS A SHARE OF GDP SOURCE: CBO, MARCH

ONE OBSTACLE, ABOVE ALL OTHERS One of the two political parties has been hi-jacked by a minority who say fiscal balance is urgent, but also say it can be done entirely by cutting domestic spending: They want to cut taxes & raise military spending at the same time as eliminating the deficit, which is mathematically impossible. Prevents any sort of deal like 1990 which slowed spending growth & raised taxes during the 1990s.

THE GAME OF “CHICKEN” In the 1955 movie Rebel Without a Cause, whoever jumps out of his car first supposedly “loses” the game. James Dean does; but the other guy miscalculates and goes over the cliff.

THE DEBT-CEILING GAME OF “CHICKEN ” In the summer of 2011, “fiscal conservatives” recklessly threatened government default, if their demands were not met. The resulting political dysfunction led S&P to downgrade US bonds from AAA to AA. A last-minute solution postponed the deadline to the end of 2012: If no action is taken then, (i) all tax cuts expire, (ii) all discretionary spending is cut drastically, & (iii) the debt ceiling law is probably violated anyway. I.e., a return of the stand-off: => Danger of recession and default !

3) RETURN OF “RISK OFF” ENVIRONMENT? Financial markets have swung back and forth between periods of risk-denying “reach for yield” & periods of risk-obsessed “flight to safety.” Risk perceptions were far too low in Shot up in ; Down in Up again?

SOVEREIGN SPREADS DEPEND ON RISK PERCEPTIONS, AS REFLECTED IN THE VIX (OPTION-IMPLIED VOLATILITY OF US STOCK MARKET) Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011 Risk on Risk off

ARE EM S VULNERABLE? Historically, international financial shocks (a rise in risk-aversion and/or interest rates) hit Emerging Markets harder than anyone: 1982: International debt crisis (esp. Latin America) 1997: East Asia crisis (spreading to Russia, Brazil…). Worryingly, EMs seem subject to15-year cycle: 7 years of capital inflow drought; 7 year of capital inflow flood; Crisis hits in 15 th year.

THE BIBLICAL CYCLE Joseph prophesied 7 years of plenty, with abundant harvests from a full Nile -- followed by 7 lean years of drought & famine. Joseph prophesied 7 years of plenty, with abundant harvests from a full Nile -- followed by 7 lean years of drought & famine. The Pharaoh empowered his technocratic official (Joseph) to save grain in the 7 years of plenty, The Pharaoh empowered his technocratic official (Joseph) to save grain in the 7 years of plenty, building up sufficient stockpiles to save the Egyptian people from starvation during the bad years. building up sufficient stockpiles to save the Egyptian people from starvation during the bad years. -- a valuable lesson for today’s government officials in industrialized & developing countries alike. -- a valuable lesson for today’s government officials in industrialized & developing countries alike. 17

BIBLICAL CYCLE, CONT. For emerging markets, the first phase of 7 years of plentiful capital flows occurred in , For emerging markets, the first phase of 7 years of plentiful capital flows occurred in , recycling petrodollars as loans to developing countries. recycling petrodollars as loans to developing countries. The international debt crisis that began in Mexico in 1982 was the catalyst for the 7 lean years, The international debt crisis that began in Mexico in 1982 was the catalyst for the 7 lean years, known in Latin America as the “lost decade.” known in Latin America as the “lost decade.” The turnaround year, 1989, saw the first issue of Brady bonds, which helped write down the debt overhang The turnaround year, 1989, saw the first issue of Brady bonds, which helped write down the debt overhang and put a line under the crisis. and put a line under the crisis. 18

BIBLICAL CYCLE, CONT. The second cycle of 7 fat years was the period of record capital flows to emerging markets in The second cycle of 7 fat years was the period of record capital flows to emerging markets in The 1997 “sudden stop” in East Asia was then followed by 7 years of capital drought. The 1997 “sudden stop” in East Asia was then followed by 7 years of capital drought. The third cycle of inflows, often identified with “carry trade” and “BRICs” came in The third cycle of inflows, often identified with “carry trade” and “BRICs” came in and persisted even through the Global Financial Crisis. and persisted even through the Global Financial Crisis. If history repeats itself, it is now time for a 3 rd sudden stop of capital flows to emerging markets! If history repeats itself, it is now time for a 3 rd sudden stop of capital flows to emerging markets! 19

ARE EMERGING MARKETS DUE FOR A CORRECTION, TRIGGERED BY A NEW WAVE OF “RISK OFF” BEHAVIOR ? Most worrisome: Turkey. Most worrisome: Turkey. Turkey can probably not sustain the rapid economic growth and very high trade deficits of recent years. Turkey can probably not sustain the rapid economic growth and very high trade deficits of recent years. Vulnerable to world oil price. Vulnerable to world oil price. China could land hard as its real-estate bubble deflates and the country’s banks are forced to work off bad loans. China could land hard as its real-estate bubble deflates and the country’s banks are forced to work off bad loans. High GDP growth rates in Latin America over the same period could reverse, High GDP growth rates in Latin America over the same period could reverse, particularly if global commodity prices fall – particularly if global commodity prices fall – Esp. if the cause is that the Chinese economy begins to falter. Esp. if the cause is that the Chinese economy begins to falter. 20

21 BUT: A REMARKABLE ROLE-REVERSAL SUGGESTS EMERGING MARKETS ARE NO LONGER SO VULNERABLE: Debt/GDP of rich countries (> 80%) is now more than twice that of emerging markets; and rising rapidly. + Even EM “debt intolerance” may be diminishing. ≡ creditworthiness for given debt/GDP -- Reinhart & Rogoff => Some EMs Economies are now more creditworthy than some Advanced Economies as reflected in credit ratings or sovereign spreads.

BUT WEAKER IN ADVANCED ECONOMIES. World Economic Outlook, IMF, April 2012 Public finances since 2001 have become much stronger in EMs

COUNTRY CREDITWORTHINESS IS NOW INTER-SHUFFLED “Advanced” Countries (Formerly) “Developing” Countries AAA Germany, UKHong Kong, Singapore AA+ US, France AA-JapanChina A+Chile, Korea A-Malaysia, Botswana BBB+Ireland, Italy, Spain South Africa, Thailand BBBBrazil BBB-Iceland Colombia, India, Indonesia BBPortugalCosta Rica, Jordan, Philippines BBurkina Faso CCGreece S&P ratings, Apr.26, 2012

ONE INDICATION OF IMPROVED EM CREDITWORTHINESS : EM SOVEREIGNS USED TO HAVE TO PAY HIGHER INTEREST RATES THAN US HIGH-YIELD CORPORATES (BB), BUT NOW PAY LESS. World Economic Outlook, IMF, April 2012

Copyright Jeffrey Frankel, HISTORIC ROLE REVERSAL IN THE CYCLICALITY OF FISCAL POLICY IN INDUSTRIALIZED VS. DEVELOPING COUNTRIES In the textbooks, benevolent governments are supposed use discretionary fiscal (& monetary) policy to dampen cyclical fluctuations. expanding at times of excess supply, and contracting at times of excess demand. But in practice, …

Copyright 2007 Jeffrey Frankel, unless otherwise noted PRO-CYCLICAL FISCAL POLICY THESE 3 PAGES WERE IN L3 APP. IN 2010 In practice, policy has often been procyclical, i.e., destabilizing, in developing countries : Governments would raise spending in booms; and then be forced to cut back in downturns. Kaminsky, Reinhart & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006), Ilzetski & Vegh (2008) and Medas & Zakharova (2009). Especially Latin American commodity-producers. Gavin & Perotti (1997), Calderón & Schmidt-Hebbel (2003), Perry (2003), and Villafuerte, Lopez-Murphy & Ossowski (2010).

procyclical } G always used to be pro-cyclical for most developing countries. countercyclical l Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours” Pro-cyclical spending Counter- cyclical spending Correlations between Gov.t Spending & GDP

AN IMPORTANT DEVELOPMENT -- IN THE LAST DECADE, SOME DEVELOPING COUNTRIES WERE ABLE TO BREAK THE HISTORIC PATTERN: They took advantage of the boom to run budget primary surpluses. and build reserves. By 2007, Latin America had reduced its debt to 33% of GDP, as compared to 63 % in the United States. And so had fiscal space to respond to the recession. I.e., some emerging market countries finally achieved countercyclical fiscal policies.

CORRELATIONS BETWEEN GOV.T SPENDING & GDP In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. Frankel, Vegh & Vuletin (2011) procyclical countercyclical

TO SUMMARIZE THE FISCAL ROLE REVERSAL, Many important emerging markets have, so far this century, achieved: Lower debt levels than advanced economies; improved credit ratings; lower sovereign spreads; and less procyclical fiscal policies.

LESS VULNERABLE TO CRISES IN OTHER RESPECTS AS WELL : More flexible exchange rates than before Higher fx reserve holdings E.g. relative to short-term debt. Less prone to current account deficits. Capital inflows less concentrated in $ bank debt And local-currency debt. More FDI. Exception: the one region that apparently didn’t learn the lessons of the 1990s was Eastern Europe.

( 4) COMMODITY PRICE VOLATILITY Prices of oil, minerals & agricultural commodities have become increasingly volatile in recent years. Especially sharp spikes in 2008 & 2011 With a crash in between. Commodity price volatility likely to continue. Whether a commodity price rise is good or bad depends on (i) whether you are a buyer or seller (ii) the cause of the increase.

COMMODITY PRICES HAVE BEEN ESPECIALLY VOLATILE OVER THE LAST DECADE Nominal prices 2010=100 Real prices * = nominal in 2000 A.Saiki, Dutch Nat.Bk.

COMMODITY PRICES SPIKED IN 2008, AND AGAIN IN SPRING 2011 Oil World Economic Outlook, IMF, April 2012

WHAT DETERMINES COMMODITY PRICES? Various idiosyncratic factors in each sector. When wheat prices go up, it could be Australian drought, Russian fires, Canadian floods, US ethanol subsidies or Argentine export controls. But when virtually all commodity prices move together, it must be macroeconomic: 70s ↑, 80s ↓, ↑, ↓, ↑. Leading explanation: global business cycle, e.g., China- led growth & Secondary explanation: monetary policy, as reflected in real interest rates.

GROWTH IN CHINA’S IMPORTS OF MINING PRODUCTS IS A BIG REASON FOR THE UPWARD TREND IN THEIR PRICES. World Economic Outlook, IMF, April 2012

OIL PRICES HAVE CONTINUED TO RISE IN THEY COULD GO MUCH HIGHER, OR MUCH LOWER. This has been idiosyncratic, not a continuation of the general commodity boom. E.g., natural gas prices are strongly down, at least in the U.S. It is attributable to geopolitical risk: Tensions with Iran. Sanctions on Iranian oil exports. The danger of military conflict which might impede access to oil from the Persian Gulf.

COLOMBIA, LIKE MOST LATIN AMERICAN COUNTRIES, IS VULNERABLE TO FURTHER SWINGS IN PRICES OF COMMODITIES ESP. OIL & COFFEE Dangers of commodity volatility include: Highly cyclical revenues; Real currency appreciation crowding out manufacturing Procyclical fiscal policy; Procyclical monetary policy.

CONTRACT DEVICES TO SHARE RISKS 1. Index contracts with foreign companies to the world commodity price. 2. Hedge commodity revenues in options markets 3. Denominate debt in terms of commodity price: Issue oil bonds & coffee bonds, instead of $ or peso bonds. Issue oil bonds & coffee bonds, instead of $ or peso bonds. Risk-manangement recommendations for commodity-exporting countries

4. Allow some currency appreciation in response to a rise in world prices of export commodities, but not free floating. Accumulate some forex reserves. 5. If the monetary regime is to be Inflation Targeting, consider using as the target, in place of the CPI, a price measure that puts weight on the export commodity (P roduct P rice T argeting ). 6. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent commodity price rises. Recommendations for commodity producers continued COUNTER-CYCLICAL MACROECONOMIC POLICY PPT

7. Manage Commodity Funds transparently & professionally, like Botswana’s Pula Fund -- not subject to politics like Norway’s Pension Fund. like Botswana’s Pula Fund -- not subject to politics like Norway’s Pension Fund. 8. Invest in education, health, & roads. 9. Buyers: Publish What You Pay. Recommendations for commodity producers, concluded GOOD GOVERNANCE INSTITUTIONS

ELABORATION ON TWO PROPOSALS TO REDUCE THE PROCYCLICALITY OF MACROECONOMIC POLICY FOR COMMODITY EXPORTERS I) To make monetary/exchange rate policy less procyclical: P roduct P rice T argeting II) To make fiscal policy less procyclical: emulate Chile. PPT

I) THE CHALLENGE OF DESIGNING A CURRENCY REGIME FOR COUNTRIES WHERE TERMS OF TRADE SHOCKS DOMINATE THE CYCLE Floating accommodates terms of trade shocks, thus giving countercyclical monetary policy; but can entail excessive exchange rate movement and does not provide a nominal anchor. Inflation targeting, in terms of the CPI, provides a nominal anchor; but can dictate a procyclical monetary policy.

Professor Jeffrey Frankel Product Price Targeting Target an index of domestic production prices. [1] Include export commodities in the index and exclude import commodities, so money tightens & the currency appreciates when world prices of export commodities rise, not when world priced of import commodities rise. Automatically countercyclical. The CPI does it backwards: It calls for appreciation when import prices rise, and not when export prices rise. [1] Frankel (2011). PPT

45