The crisis hits emerging markets

We are used to hearing that global growth is being driven by emerging markets. In the original Goldman Sachs study that coined the term “the BRICs”, it was estimated that by 2020 the BRICs would account for 49% of global GNP. In 2010, the figure was already 36%. Increasingly responsible for propping up the global economy, many believe that the future lies in emerging economies. When European leaders recently courted China as a possible buyer of troubled government bonds, the idea of emerging economies bailing out their erstwhile masters seemed complete.

The picture is in fact more nuanced for many different reasons. In an excellent recent study, Zaki Laïdi notes that the political demands of the BRICs are ambivalent: they defend national sovereignty in ways that prevents them from developing a shared political project of their own. In economic terms, the notion of a fundamental shift from the North America and Western Europe towards Brazil, China and India also needs to be nuanced.

The dependence of these emerging markets on the state of the economies in North America and in Western Europe is striking. In 2009 the world economy as a whole went through only a minor downturn, largely because of the offsetting growth in emerging markets. In 2010 and 2011, the picture has been rather different. Looking at growth rates across OECD and non-OECD countries, what is striking is how closely matched they are. The latter group consistently post higher growth rates but these rates rise and fall in line with growth in OECD countries.

This correlation in growth trends doesn’t mean the rich world is driving growth in emerging markets. But there are some powerful ways in which the problems in OECD economies have begun to feed through into emerging markets. Two channels in particular stand out. One is a fall in consumption in the US and Western Europe, resulting in a decline in demand for primary and secondary products exported out of emerging economies. On December 1^st, it was reported that China’s manufacturing sector contracted for the first time in almost three years. As the chart below shows, after a sharp downturn then upwards spike in the course of 2008, the rate of expansion of factory output in China has been declining steadily.

The second channel is via the withdrawal of foreign capital because of the pressure on Europe’s financial system. As banks reduce their exposures, those emerging economies dependent upon foreign bank lending are in difficulties. This exit of foreign capital and a declining demand for national currencies such as the Brazilian real or the Turkish lira is having inflationary consequences: as the currencies depreciate, the cost of imports rise, pushing up the general price level. This bites into the competitiveness of these economies as wage demands respond to higher living costs (NB. this is one reason Germany wants to avoid seeing the ECB stoke inflation in the Eurozone – it would undermine its ability to contain wage demands and thus challenge its own competitiveness model). According to the Basel-based Bank for International Settlements, emerging markets owe 3.4 trillion US dollars to European banks; 1.3 trillion US dollars of that is owed by Eastern European countries. According to The Economist, as European banks deleverage downward pressure will be placed on many emerging markets. This is particularly serious for those countries – like Turkey – who run large current account deficits. They are dependent upon foreign capital to manage these deficits.

What the figures imply for the role of the emerging markets in the global economy is far from clear. But the exposure of these economies to the events in North America and Western Europe is obvious. To declare the irrelevance of these two regions in the face of the rise of China or of India is to miss the extent to which growth in emerging markets is dependent upon OECD economies.

Guest Post: Europe and Democratic Funding

Editors’ Note: The European banking crisis continues to unsettle markets, and to raise serious doubts about not just the economic but also political future of current European institutions. As our guest post today by Anush Kapadia points out, underlying the turmoil is the achingly familiar ‘democratic deficit’ problem, but this time present in a new form. The basic democratic challenge this time reaches beyond the question of the EU’s institutional structure to the question of how its member states, and supranational institutions, relate to (financial) markets. As Kapadia points out, this democratic challenge, though it has special characteristics in the European case, is a general one facing any state seeking funding yet also seeking to retain enough autonomy to remain under the control of its citizens.

Europe and Democratic Funding

Anush Kapadia

The European crisis is one of legitimacy, not of the European project per se but of the financial fundamentals of moderns states. The lopsided nature of the European project merely serves to highlight the potentially undemocratic side of the financial undergirding of state power. It also foreshadows a potential solution to the problem.

It is not hard to notice that while scorn is routinely reserved for the unelected Eurocrats who want to squash national sovereignty, very little seems to be said about the legitimacy of unelected markets dictating terms to sovereign states. Morality, it seems, is on the side of the creditor: sovereigns, like us ordinary folk, should pay their debts.

But sovereigns, like people, have a responsibility to maintain their own autonomy to the extent they can. When governments fund themselves in ways that put their sovereignty at risk, they are abrogating their democratic duty. This is the double-edged nature of government borrowing: democracy can be aided by the flexibility and liquidity of marketing government debt, but beyond a point debt turns to poison.

So how can democratic states take advantage of the bond markets without being consumed by them?

The answer from creditor-morality is simple: don’t borrow beyond your means. And there is truth in this homily. The problem of course is that the very extent of ones means is subject to the judgment of the self-same creditor. To a large degree, solvency is in the eye of the creditor.

For any economic unit, the pattern of cash inflows rarely maps perfectly on to the pattern of cash outflows. Individual cash (dis)hoarding can of course mitigate this mismatch; what we call “banking” is merely the socialization of this liquidity-matching function: units with excess inflow lend to units facing outflow constraints via the intermediation of a bank. If the matching process stops, a borrowing unit’s cash commitments can swamp its cash inflows: the unit is dead. If your creditors stop rolling over your debt, the music stops very quickly indeed.

Prudence dictates that the unit steer clear of such peril. Yet when faced with myriad constraints, units will load up on credit if that dimension is eased. The market price of the unit’s debt is meant to be an indicator of proximity to peril. Yet as we have seen, this indicator is notoriously fickle: one day the unit is extremely creditworthy, the next day it’s bust.

Now especially if the economic unit is a democratic state, it has a solemn duty to avoid such peril. This means that it has a solemn duty to avoid fickle funding. And this in turn means avoiding the bond market beyond the point of prudence.

This is exactly what Europe has been groping towards, willy nilly. It is precisely because Europe lacks a common fiscal authority that it is seeking this solution. In so doing, it foreshadows a more democratic method of state funding.

Most see Europe as an unfinished federal project and indeed weak on that score. What they miss is that Europe is a new experiment in interstate relations, not a slow-motion rerun of US history. The people of Europe do not want to be part of a federal state. This is axiomatic; it renders the nation-state analogy for Europe nugatory. Our imaginations are constrained by this nation-state frame.

This national impossibility is what ultimately ties the hands of the ECB as an effective lender of last resort; its paranoid ideology is merely icing on the cake. A prudent lender of last resort mitigates the fickle nature of market funding by stabilizing the credit system as a whole when the market mood inevitably turns. This function can only perform its stabilizing work if it has credibility; it has credibility because it is backed by a fiscal authority.

Thus if the ECB were to act as an adequate lender of last resort in this crisis, it would implicitly call into being the absent European fiscal authority. And this cannot happen because the European people don’t want it. The Bundestag is merely the institutional expression of this desire. Of course, if the ECB acts as a lender of last resort in this crisis without at least implicitly calling into being a common fiscal leviathan, the ECB itself will take the place of the impaired sovereigns as the target for the markets. A lender of last resort without fiscal backing is not credible; the markets will gnaw away at it until implicit backing is made explicit. The assets that the ECB purchases will lose value to the point where the ECB’s own balance sheet will start to look shaky; the Euro itself would start to melt away.

Hence all the machinations around the EFSF (recent summit statement here). One can see how this institution might be the kernel of a common fiscal authority, at least in its borrowing power if not (yet) its taxation power. And that’s what the fight is about now. The Germans want to keep it small and limited so that it won’t prefigure some kind of common fiscal mechanism, but if it’s too small it’s not credible enough to function as a lender of last resort.

So no ECB, no EFSF. And the markets are completely roiled. Where oh where can a distress sovereign go for funding? China.

Well, not literally, but certainly figuratively. With the ECB and EFSF hamstrung because of the latent common fiscality they imply, Eurocrats have to find another set of balance sheets with spare capacity. This is where the special-purpose-investment-vehicle (SPIV) solution enters the fray.

Without getting into the details, there are two current plans to bolster the capacity of the EFSF (ignoring the somewhat loopy French plan to turn it into a bank): make it an insurance company or make it a kind of collateralized debt obligation (remember those?). There might be some combination of these solutions, but the latter is the one to focus on.

Floating a SPIV by the EFSF means that the latter would create and underwrite an entity that would issue highly-rated bonds; the proceeds of this sale would be used to buy encumbered sovereign debt. (Note: The same structure was used to by mortgages; the resulting securities were thus called mortgage-backed securities. The same tranche structure is envisioned here so that private money take come in and take the more risky elements of the vehicle). And who are the potential sources of funding for this vehicle? Sovereign wealth funds and other “international public investors.” The patient, institutional capital, in other words, not the fickle market money.

Since these new investors have very deep pockets and have their eye on the very long-term (some of them are sovereigns themselves after all), they are not subject to the same incentives as normal players in the bond market. The latter tend to be highly-leverage and work on the narrowest of margins. Having drastically underpriced sovereign risk, the fickle money markets are now drastically overpricing it; yesterday’s promise of growth has turned in today’s demand for austerity. Long-term investors look at long-term value rather than short-term prices; think Buffet rather than Bear. These investors would typically hold the bonds to maturity and can ride out short-term fluctuations because of their deep pockets. And at the moment they are getting a deal.

The absence of a common fiscal authority in Europe has lead to a credibility crisis at its heart. Most see the solution to this as an aping of the history of the nation-state: “build a fisc already!”, this position screams. But that way is closed to Europe. They are charting a new history.

Because of these constraints, the Europeans are finding that another route to stability is in effect to de-marketize some portion of their sovereign debt and place it with buy-and-hold institutions. What we might consider is that Europe’s ex post crisis response might be a way of insulating democratic states from the fickle markets ex ante.

The analogy with bank funding is clear: part of the problem with banks leading up to the crisis was that they were funding in highly liquid markets at ever-shorter maturities and in ever-greater proportions. This made them vulnerable to a run; subprime burst the bubble and the inevitable run followed. What is the proposed solution? Mandatory funding durations imposed by the regulators: long-term assets ought to be funded by long-term liabilities to the extent possible.

The state is a long-term asset, our long-term asset. It needs a funding structure adequate to its long-term democratic duties. A state simply cannot legitimately allow itself to be bossed around by the markets. This means that the state (and the banks it underwrites) should not be allowed to fund in fickle markets beyond a certain point; no matter how cheap and liquid this funding appears, the cycle will turn and austerity will result.

The East Asians learned this after their crisis and responded with cash hoarding. But this is globally suboptimal: banking was invented so that we wouldn’t all have to keep our cash under our mattresses. Better lend it out to those who need it; if we are long-term savers, we can afford to lock it up for a while.

That’s what pension funds do; that’s what sovereign wealth funds do. We know that how we fund our governments matters for its legitimacy, but our democratic common sense ties only taxation to representation. Yet the structure of state borrowing is equally critical. It is to this patient structure of funding that Europe’s experiment now turns, at least at the critical margin. There might be a lesson in there for all of us.

Looking for growth

We have often argued at The Current Moment that what is missing in both the US and Europe is a real plan about how to make these economies grow. The political right points to the need for tax cuts; the left prefers state-funded jobs programmes. Neither addresses the problem of a languishing private sector, where firms are sitting on cash rather than reinvesting it. Central banks have tried to stimulate the economy by pushing down interest rates as way of stimulating private borrowing. As argued before (here), quantitative easing has not had the desired effect.

One response to the current problems is to point to the need to get consumers spending again. Firms are sitting on cash because they are gloomy about the future: without more buoyant demand, more investment will only mean the production of unsold goods. Critics of the austerity measures being pushed through across Europe often frame their opposition in terms of its effect on demand: how can European economies grow if the continent’s consumers are being hit with new taxes, cuts in welfare incomes and job losses?

This consumption-oriented view of growth is worth comparing with the growth experiences of the emerging markets. Growth does not just come from consumption. In fact, things look rather different if you look outside of the US and Western Europe. Take China. In its recent World Economy report, The Economist notes that the percentage of the gross national product that is consumed has fallen steadily in China since the 1970s.

If we were to map China’s annual growth figures on the graph, the relationship between consumption and growth would be an inverse one: a rise in the latter as the former has fallen. This makes sense if we look at how Chinese investment decisions are made. Capital is channelled via state-controlled banks into production. The percentage of the GDP that is reinvested is remarkably high in China: around 50% of GDP. It is on average half of that in OECD countries.

One way of looking at the contemporary slump in Western Europe and the US is through the lens of productive investment rather than that of consumption. The Chinese model has its own limitations, not least its reliance upon the demand for its exports in overseas markets. China is also at a different stage of its development, meaning that we are not comparing like with like. But it is nevertheless useful as a way of generating different sorts of questions. In what ways are investment decisions made? By whom and with what goals exactly? And crucially, how has the role of financial intermediaries changed over time and what impact have those changes had on investment? We don’t have answers to these questions yet but they are a good place to start when thinking about the growth problems in contemporary Europe and in the US.