China Research

A discussion forum on emerging markets, mainly China – from a macro, micro, institutional and corporate angle.

Capital Markets in Emerging Economies

May 8, 2013

Many private households and financial institutions in our part of the world do not know anymore where and how to invest their money. Saving accounts may even give a negative real return. The German insurance giant Allianz refrains from new investments in bonds because of the low yields. More examples could be mentioned.

Investing in stocks?  Yes – or maybe. But the mood on a number of stock exchanges may be better than the outlook for the real economy. China gives some doubt even what regards the short-term prospects of the economy. So do other emerging economies with working stock markets such as Indonesia, Brazil and Russia.

What about investments in real estate? There is (still) an increasing demand in a number of industrial countries since credits are cheap at many places (e.g. Germany, Sweden). However, not many investors have the resources to be active on this kind of market. The risk of a (new) bubble may emerge in the future.

Could “safe” bonds be something to invest in? In the past, government bonds in many mature countries were regarded as fundamentally safe. The European debt crisis tells us now a different or modified story. For this reason, nobody can be surprised that bonds in emerging markets increasingly are promoted by financial institutions at the expense of bonds in OECD countries. What about the emerging-market alternative?

We know from stock markets that investments in mature economies can fail from a country risk perspective, too. Failures are not an issue that are exclusively related to emerging markets. Despite – normally – major institutional shortcomings, stock market investments in emerging countries may be successful at least in the shorter perspective. But there is, of course, no guarantee for good (trend) developments. Negative turnarounds may show up very suddenly on emerging capital markets. Certain negative events may lead to massive sales by (mainly?) Western investors, and – consequently – to sharp falls of stock prices.

Bond markets in emerging markets usually have even larger structural weaknesses. Normally, bond markets in these countries are institutionally lagging behind modern and transparent models even more than stock markets. China may serve as an illustrative example. It should be kept in mind that most emerging countries do not even have a bond market.

Furthermore, the volume of tradable bonds in emerging countries – if such trading conditions exist at all – tends to be very limited. Before investing in emerging market bonds, it should be a good idea to further analyze the institutional conditions of the relevant country very carefully – turnover/liquidity and transparency of bond markets included. These shortcomings may counteract – on average – more healthy fiscal numbers in many emerging countries compared to traditional OECD countries.  Exactly these favorable fiscal indicators in quite a number of emerging economies serve nowadays frequently as arguments for purchasing emerging market bonds.

Sure, there may be more promising bond alternatives on emerging bond markets I do not know about. In general terms, however, question marks what concerns investments in emerging market bonds should be very large. Macroeconomic indicators do not tell the whole truth. Microeconomic and institutional conditions must be considered as well.

Thus, the run for somewhat higher yields – for instance to emerging economies – is not all in financial life. Memory on financial markets is usually quite short – as the heavy involvement of Swedish banks in the recent Baltic disaster clearly shows – just 15 years after the severe banking crisis in the first half of the 1990s!

And we also get these days reminded again that very low interest rates during a longer period of time many times provoke increasingly risky investments. This may be the main reason for the current strengthening marketing of emerging market bonds.

But have we already forgotten the origins of the American subprime crisis just a few years ago?

 
 

Hubert Fromlet
Professor of International Economics
Editorial board

 

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Is China Headed for Stagnation?

April 3, 2013

Last year, economists Daron Acemoglu and James Robinson published their ground-breaking analysis of the crucial role that institutions play in determining economic development. One of the boldest and most controversial claims made in Why Nations Fail: The Origins of Power, Prosperity, and Poverty is that the Chinese economy will stumble badly, leading to sharply lower growth. The authors don’t put a fixed date on when this event will occur, but they are not talking simply about growth slowing from the 8–10 per cent range to the 4–6 per cent range (something that most economists believe is inevitable as an economy matures). Instead, Acemoglu and Robinson contend that China is in for the type of economic stagnation that the Soviet Union experienced before its collapse or that Japan has been experiencing since the early 1990s.

What do the authors base this claim on? They have two closely related insights. The first is that institutions are important for economic growth, and the second is that the degree to which a country develops sound institutions depends on the political system that evolves in a country over time. Bad institutions are a result of political systems that generate huge financial gains for the elite members of society at the expense of everyone else.

The contrast between North and South Korea also illustrates the effect that political and economic institutions have on economic development. South Korea has what the authors refer to as “inclusive” political and economic institutions that attempt to distribute power evenly in society and try not favour one group over another. Political power rests with a broad range of interest groups. South Koreans have access to proper education and are permitted to own property, start a business, or obtain a mortgage. This contrasts sharply with the extractive political and economic institutions in North Korea that narrowly concentrate political power and that force people to toil mainly for the benefit of the country’s ruler and a small segment of society with ties to the ruling party.

China certainly has extractive institutions. The country still does not have well-defined property rights and it remains a communist dictatorship. Stories in the media about sudden expropriations of farmers’ land by government to build a factory or make way for a dam are still common. The farmers who are displaced have little recourse in these situations.

The authors cite the arrest of Dai Guofang by Chinese leaders in 2003 as evidence of the serious flaw in China’s institutions. Dai’s crime was to start up a low-cost steel company that could compete with Communist Party-sponsored operations. The ruling party in China won’t permit companies with crucial links to the Communist Party to fail even if they are inefficient and lose money. And because the Chinese government will not permit these inefficient companies to fail, the economic system in China will never innovate to the degree essential to generate sustainable economic growth. Eventually growth will grind to a halt as the productivity gains realized by massive numbers of people moving from rural to urban parts of the country start to wane.

Critics of the authors’ views on China point out that for over three decades the Chinese economic model, which combines some elements of a market economy with extractive political institutions that protect the interests of the Communist Party, has generated rapid economic growth and lifted millions of people out of poverty. There is no reason why this can’t continue, they argue, although it is widely agreed that more modest growth will eventually occur in China.

The authors agree that it is possible for a country to attain high economic growth with extractive political institutions for a long period of time—but not indefinitely. They point out that the former Soviet Union’s economy initially experienced rapid growth despite having weak institutions that protected the interests of Communist Party members at the expense of the rest of society. In fact, between 1928 and 1960, national income in Russia grew by an average of 6 per cent per year.

In 1956, then-Soviet leader Nikita Khrushchev cited the rapid economic growth in his country and boasted to Western powers that “We will bury you!” Soviet leaders were able to engineer high economic growth by undertaking a massive program of industrialization. However, a lack of economic incentives and innovation in the Soviet system meant that economic growth couldn’t be sustained once the shifting of resources from rural to urban areas of the Soviet Union had been completed. A similar fate awaits China, according to the authors of Why Nations Fail.

It is possible that China could still avoid that fate if its leaders gradually introduce democratic reforms that lead to the more inclusive political institutions the authors say are crucial for long-term economic growth. Perhaps Chinese leaders will eventually follow the South Korean model, in which a dictatorship initially implemented economic reforms that resulted in surging economic growth. That was gradually followed by reforms, which eventually led to a successful democracy taking hold in South Korea. Skeptics correctly point out that, to date, the Chinese Communist Party has given no indication that it intends to reform itself out of existence. However, the country does have new leadership, and we should soon have a clearer idea about the path that China will follow.

Sources: Daron Acemoglu and James Robinson, Why Nations Fail: The Origins of Power, Prosperity, and Poverty (New York: Random House, 2012); Francis Fukuyama, “Acemoglu and Robinson on Why Nations Fail,” The American Interest (March 26, 2012).

Kip Beckman
Principal Economist, World Outlook Forecasting and Economic Analysis, The Conference Board of Canada, Ottawa

 

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Is Latvia Really Mature for the Euro?

A couple of weeks ago, Latvia decided to apply for EMU/euro membership from 2014. This is an understandable step – but is it also a wise decision? I do have my doubts.

Sure, Estonia joined the euro in 2011. But all three Baltic States have their own characteristics; my own experience tells me that Estonia still should be regarded as the most flexible Baltic country. Latvia’s return to reasonable GDP growth at currently around 5 percent certainly has to be considered as a remarkable performance after the turmoil of 2008-2010 in a pure macroeconomic perspective (which many foreign analysts – unfortunately – tend to prefer).  We should, however,  not forget that pain was quite strong for major parts of the Latvian population as a result of the internal devaluation in the past years – and that Latvia could not come on the  track of recovery without the support of the EU and the IMF.

My main arguments against Latvia’s joining of the euro already next year look as follows:

1) It is certainly no secret that Latvian public and political opposition to the lats’ euro entry is relatively strong. Such a constellation is no good starting point for a new exchange rate regime.

2) The Latvian economy was confronted with a severe economic crisis only 3-4 years ago. Thus, we do not know very much about the sustainability of the competitive progress that could be achieved by the internal devaluation.

3) A couple of years ago, the current account deficit of Latvia exceeded 20 percent of GDP – a horrible ratio! Currently, the situation looks better. But what will happen to the current account 5 to 10 years from now when the effects of the internal devaluation probably will have been wiped out (more or less)? I doubt whether Latvia in a couple of years will have achieved a structurally healthy current account balance. Of course, I hope this will be the case.

4) One of the main problems to come to a persistently favorable development of the current account is the very difficult process toward a new and modernized structure of Latvian exports with good qualitative and technological competitiveness on tough global markets. The way to such a fundamental change will be very, very bumpy – with a very uncertain outcome.

5) Right now, the Latvian government seems to have a feeling that the safety net for its currency, the huge bank lending in euro, and the banking system ought to regarded as more stable within the Eurozone than outside. Recent experience, however, tells us a different story. Small countries cannot be too small to fail! A little reminder: At present, the small EU/EMU country of Slovenia – having roughly the same population as Latvia – seems to give increasing reasons for concerns.

6) One of the worst disadvantages that could be watched already before the financial bubble burst in 2008, was the absence of an independent monetary policy because of Latvia’s membership in the ERM2 system, the final currency step of EMU preparation before joining the monetary union. If the instrument of an independent monetary policy still had been in place between 2006 and 2008, much misery could have been avoided in the following years (GDP loss more than 20 percent).

In other words: Only very competitive and fundamentally strong economies can afford the loss of national monetary policy decisions as a tool for adjusting or changing wrong developments at home.

Thus, the conclusion should be that Latvia should wait at least another business cycle – which could be 5-8 years – before the idea of joining the euro may be re-considered!

 

Hubert Fromlet
Professor of International Economics
Editorial board

 

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