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FINANCIAL TIMES
The premature ageing of emerging market economies
Growth advantage over mature markets has halved and is set to
disappear
Hung Tran
The 2018 annus horribilis has put emerging market assets in a
competitive situation: they are undervalued both historically (with
equity price/earnings and price/book ratios below their 2000-18 averages
and currencies undervalued) and relative to their mature market
counterparts (especially offering higher real yields).
EM assets are still underweighted in global portfolios. As such, EMs are
in a good cyclical position to recover when the global growth outlook
stabilises, adjusting to the new normal of ongoing trade and political
tensions.
Beyond this near-term view, however, the long-term case for diversifying
into EM assets needs to be recalibrated, because many EM countries are
faced with growing structural headwinds. Basically, they reflect a
premature “ageing” of EM economies.
Most important is the ageing of many EM populations, albeit from a
younger age structure than in mature markets. According to UN
projections, the old age dependency ratio in EMs (65+ over the working
age population) will rise from about 10 per cent at present to more than
22 per cent by 2050; the comparable increase in mature markets is from
28 per cent to 45 per cent.
In particular, except for India and Africa, EM labour force growth has
slowed and actually declined in countries such as China (thanks to its
one-child policy). .
In addition, productivity growth has shown signs of resuming its earlier
trend of slowing since the 1960s after a recovery in the early 2000s.
According to the IMF, for EMs excluding China, total factor productivity
growth decelerated from about 2.5 per cent a year in the 1970s to minus
1 per cent in the early 1990s, then recovering to almost 1 per cent in
the early 2010s before slowing down again.
Similarly, labour productivity growth recovered strongly from the early
1990s to more than 3 per cent, driven by a quickened pace of capital
accumulation thanks to low financing costs, but has recently shown signs
of topping out.
Besides factors such as reform and capital deepening, which can promote
productivity growth, other factors exert a negative influence on
long-term productivity performance — such as the premature
deindustrialisation in many EMs and developing countries.
In recent decades, the share of manufacturing employment and value added
in those economies has peaked and declined earlier in their development
process and at lower levels of per capita income. This is in comparison
with their own performance before the 1980s and especially relative to
the experience of mature markets. To the extent that manufacturing
activity and jobs tend to exhibit higher levels of productivity, the
premature relative decline of manufacturing in favour of the service
sector (which has grown to more than 53 per cent of GDP from 45 per cent
in the 1990s) can dampen overall productivity growth.
Interestingly, modern technological changes can both help promote
inclusive development in EMs (for example, in the case of the M-Pesa
mobile payment system in Kenya) but also hinder their industrialisation
efforts by emphasising trade in services and intangibles at the expense
of manufacturing for export, which had been the main route for the
industrialisation of the East Asian Tigers and China.
Such a shift into services, whose share of total exports rose from 17
per cent in 1979 to 24 per cent in 2017, can amplify the negative impact
of rising protectionism on world merchandise trade, where EMs have a
higher share (44 per cent) than in services (34 per cent). In addition,
some major countries such as the US try to unwind global supply chains,
preferring automation at home to (less) cheap labour overseas — thus
also cutting back on trade in intermediate goods. Overall, a continued
slowdown in world trade will weaken a key motor of growth for many EM
countries.
Altogether, those trends combine to lower the EM potential growth rate.
Indeed, after a growth spurt of more than 6 per cent a year in the first
decade of the millennium — driven by a wave of reforms adopted after
earlier financial crises in Latin America, Asia and Russia — EM growth
has slowed to about 4.5 per cent at present.
In part, this reflects the exhaustion of the benefits of earlier reform
measures — such as the adoption of more flexible exchange rates,
inflation targeting, reserve accumulation and efforts to improve fiscal
sustainability including some pension reform — while the pace of
additional reform has stopped or even reversed as reform fatigue sets
in. In the long run, according to the OECD, the potential growth rate of
the Briics (Brazil, Russia, India, Indonesia, China and South Africa —
accounting for most of EM GDP) is expected to slow further, converging
to mature market trend growth of 2 per cent.
In other words, the growth advantage of more than 4 percentage points
that EMs enjoyed over mature markets in the 2000-2010 period has
narrowed to about 2 percentage points and will probably disappear in the
long run.
This potential growth slowdown puts the recent increase in EM debt in a
more worrisome light. Debt has risen to a record amount of $71tn in the
second quarter of 2018, according to IIF data. While government debt for
EMs as a whole is relatively low at 48 per cent of GDP (compared with
109 per cent in mature markets) several countries such as Brazil and
Hungary have high levels of government debt. More concerning is
non-financial corporate sector debt, which at 95 per cent of GDP is
higher than in mature markets (91 per cent).
Such high levels of outstanding debt, especially in light of rising
financing costs, will make it more difficult for EM corporations to
incur sufficient new debt to sustain investment and growth. This is
particularly the case as it now takes more debt to produce the same
amount of growth than before.
Moreover, the current EM debt burden will make it more difficult to fund
and build up pension assets to provide for future retirees. Except for
South Africa and Chile, most EM countries have very low levels of
pension assets in funded and private pension schemes — less than 25 per
cent of GDP, which is much less than countries such as the UK (77 per
cent) and the US (118 per cent). This will put pressure on public
“pay-as-you-go” pension systems in EM countries, especially if
government deficits and debt cannot be brought under control.
Ultimately, failure to adequately provision for future retirees can
create social tension, not conducive to growth.
In conclusion, the case for global investors especially pension funds to
diversify into EM assets (younger population, higher growth and
potentially superior return) is still reasonable for the foreseeable
future. However, in the long run, this case depends critically on
whether policymakers in EMs can implement appropriate policies to tackle
the structural problems mentioned above, to improve productivity and
foster inclusive growth.
In this race, some countries will do better than others. Hence, the key
in EM investing is to be selective in picking country and stock
exposures — and not treating EMs as a homogeneous bloc. After all, for
2018 the dispersal of US dollar-adjusted returns among different EM
equity markets is much wider (48 percentage points, between minus 54 per
cent in Argentina and minus 6 per cent in Russia) than between the MSCI
World and EM indices (5 percentage points).
Hung Tran is former executive
managing director of the Institute of International Finance and former
deputy director of the IMF |