February 2016

29 February 2016

Brexit and emerging markets

The G20 finance ministers and central bank governments declared on 27 February that the U.K. leaving the E.U. would be a “shock” for the world economy. It is naturally difficult to assess the implication of a Brexit. Attention is focused mostly on the U.K. and the E.U. but emerging markets may be relative winners.

Prima facie evidence suggests that emerging markets excluding China fare better when the E.U. excluding Germany does badly. The share of emerging markets in world GDP tends to rise when the E.U. declines and vice versa. This would support the view that a Brexit-induced calamity for the E.U. and the U.K. could actually benefit emerging markets at least in relative terms. The EU and emerging markets recently shared a period of parallel movements since 2013. However, on average there seems to be a strong negative correlation between economic performance of the E.U. and emerging markets (Chart).

The growth performance of the E.U. relative to emerging markets rests largely on the assumption of trade and investment diversions. Poor prospects in the E.U. may divert resources towards emerging markets. The main transmission mechanisms for first round effects appear to be international trade, portfolio investments and foreign direct investment.

In international trade, emerging markets may benefit in relative terms as the U.K. runs a significantly higher deficit with advanced economies of US$110 billion in 2014 and in particular the E.U. of US$124 billion than with emerging markets excluding China of US$37 billion. Assuming that after a Brexit, the U.K. will no longer be able to sustain a large current deficit, the E.U. would suffer the most.

In international portfolio flows, the U.K. represents one of the most important sources, second to the U.S., of international portfolio assets. It equally faces large portfolio liabilities. Given that the U.K. is an important intermediary of portfolio flows, the net effect of a collapse of portfolio flows due a suspension or important impairment of international portfolio flow intermediation is unclear. Portfolio claims by the U.K. on emerging markets including China and excluding off-shore financial centres represent in 2014 about 13 percent of total international portfolio claims by the U.K. or 10 percent of world total portfolio claims on emerging markets. A Brexit-induced weakening of the U.K.’s capacity to invest or intermediate portfolio flows would be important in absolute terms but it would disproportionately affect advanced economies.

In international foreign direct investment flows, the U.K. has been a large net recipient of foreign direct investment. If it ceases to be an attractive investment destination following a Brexit, other countries are likely to benefit. The U.K. has remained a small direct investor in emerging markets, representing in 2014 4 percent of total foreign direct investment in emerging markets and China, so a decline in U.K. outward investment will be felt less in emerging markets.

Naturally, the true implication of a Brexit remains speculative and the second round effects may be far more important. Similarly, in absolute terms, a Brexit may cause generally less supportive conditions with every country suffering. Notwithstanding, emerging markets seem set to gain from a Brexit.

EU and EM divergence

Intra-emerging markets growth

The gloom about emerging markets does not seem to be reflected in recent economic projections. While by most accounts, emerging markets seem in a tailspin, significant differences in economic performance tell a different story. The G20 finance minister and central bank governor communique of 27 February underlines that “growth in key emerging markets economies remains strong,” based on IMF data. However, it depends on the region.

The IMF performs its GDP growth projections on the basis of weighted averages where the weight is GDP expressed in purchasing power terms (PPP). As PPP inflates GDP of large relatively poor countries, China and India weigh heavily in average weighted GDP. With China and India on average growing faster than many countries, PPP GDP-weighted GDP growth overstates actual—PPP GDP remains largely a theoretical concept as there are no economic transactions in international prices—GDP growth, e.g. the average PPP GDP-weighted GDP growth in 2000-2015 was 3.9 percent and the average US$-GDP weighted GDP growth rate was 2.9 percent. At the same time, the more homogenous a group of countries, the less the difference between PPP and US$ GDP matters.

The different emerging markets region show important variances in intra-regional GDP growth rates. The difference between PPP-GDP weighted GDP growth and unweighted GDP illustrates how representative GDP growth of the large populous countries compares with the average. In Asia, China and India are pulling the average up, given the positive difference between growth in PPP-GDP terms and in unweighted terms. In Africa, there has been some convergence of growth rates between the larger and other economies. In Latin America, the smaller economies have significantly outperformed the larger ones. The average emerging market growth rates continues to benefit from the better performance of the large populous emerging markets countries with Brazil being the notable exception (Chart). This may justify some of the doom.

Key countries naturally may or may not be representative of their reference groups. The dilemma with emerging markets is that large countries like Brazil and Russia may unduly contaminate perception that emerging markets perform poorly. At the same time, China and India are positive outliers. The difference between weighted and unweighted GDP growth rates illustrates that intra-regional differences and overall performance differences may be important. Differentiation therefore remains the key challenge. The notion of emerging markets seems to become less and less representative for the average emerging market on the positive as on the negative side.

PPP GDP growth rates

G20 communique mixed messages

The G20 may offer a cosier environment for discussions than the IMF. This is probably the main reason why it exists in the first place. The list of participants at finance minister and central bank governors is identical to countries’ representation at the IMF. It means that any message the IMF gives to the G20 and vice versa, is identical to the messages exchanged in Washington. It naturally leads to repeated duplication of messages. The lack of actual coordination suggests it may also lead to obfuscation.

The communique of finance ministers and central bank governors of 27 February reaffirms the G20 commitment on exchange rates: “We reiterate that excess volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will consult closely on exchange markets. We reaffirm our previous exchange rate commitments, including that we will refrain from competitive devaluations and we will not target our exchange rates for competitive purposes.”

The IMF Articles of Agreement, under Article IV, section 1, general obligations of members, reads: “[…] Each member [country] shall: (i) endeavour to direct its economic and financial policies toward the objective of fostering orderly economic growth […]; avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.” The G20 commitment is an obligation under the IMF Articles of Agreement.

The weaker language in the G20 communique is a reflection of the lack of actual commitment. Exchange rates have rarely been more disorderly than since 2000 (Chart). This has occurred despite near convergence of inflation across the leading advanced economies. It is a sign of a lack if not breakdown of economic policy coordination.

EUR JPY GDP

G20 and the IMF

The G20 finance ministers and central bank governors communique of 27 February provides a long to-do-list for the IMF. This is somewhat problematic given that the G20 lacks the legitimacy—the G20 remains an ad hoc body while the IMF is based on an international treaty—of the IMF. At the same time, the voting power of the G20 at the IMF ensures that the G20 can get what it wants but not always.

The voting power at the IMF, and hence countries’ say in the institution, has shifted with the implementation of the 2010 IMF quota reform that entered into force on 26 January. The new distribution of voting power, to date as countries’ shares are adjusted to the extent that they pay for their quota increases, show the new world order (Chart). Casual observers may feel that not much has changed.

The IMF makes most decision by simple majorities. This implies that the G20 can indeed take most decisions on its own. However, important IMF policy changes may require majorities of 75 percent and 85 percent—SDR allocations and quota increases—of the voting power. Even the G20 will therefore be required from time to time to rally support from the lesser countries.

IMF voting shares 27 Feb 2016

Economics Commentary, February 2016