151216 em outlook

Emerging Markets Outlook

Group Economics Emerging Markets Research

16 December 2015

The ‘Force’ abates: modest recovery in 2016 • In 2015, emerging markets (EMs) faced several negative forces: lower commodity prices, weak global trade and China/Fed induced capital outflows • Divergence between regions and amongst BRICs has widened • With headwinds fading and FX corrections supporting external adjustment, we expect economic growth in EMs to recover modestly in 2016-17 • However, risks (Fed lift-off/capital outflows/tighter financial conditions, high debt, China hard landing, geopolitics) are still clearly tilted to the downside.

Arjen van Dijkhuizen Senior Economist Tel: +31 20 628 8052 arjen.van.dijkhuizen@nl.abnamro.com

Introduction In late November, we published our Global economic outlook, Cautious optimism warranted.

In the first chapter of this publication, our Chief economist Han de Jong explains that the global outlook for 2016 and beyond hinges on a couple of questions. A crucial one is whether emerging economies can deal with the challenges they have struggled with in 2015.

His answer is a cautious ‘yes’, although he adds that the risks of a less favourable development than we are forecasting in our base case are relatively high. In this publication, we zoom in on developments in EMs and their prospects, the divergence between various regions/countries and the risks that could interfere with our base scenario of a modest economic recovery for EMs in 2016-17.

EM growth drops to lowest level since global crisis

Growth divergence has widened across regions …

% yoy

% yoy

15

15 10

10

5 5

0 0

-5 -10

-5 90

95

00

05

Emerging + developing economies Sources: Thomson Reuters Datastream, IMF

10

15

Advanced economies

06

07

08

Emerging Asia

09

10

11

12

13

Emerging Europe

14

Latin America

Sources: Bloomberg, Thomson Reuters Datastream, ABN AMRO

As headwinds intensify, EM growth drops significantly in 2015 2015 has been a tough year for EMs. On average, EMs are still growing faster than advanced economies, but the relative momentum has turned and EM growth is clearly below trend. EM growth has continued to fall since 2010, with a strong slowdown in 2015 (by 0.7 %-point, to 3.7%). This reflects several headwinds. First, the negative effects of the sharp drop in commodity prices on commodity exporters outweigh the positive windfall

Insights.abnamro.nl/en

15

2

Emerging Markets Outlook - The ‘Force’ abates: modest recovery in 2016 – 16 December 2015

effects for net importers. Second, weak external demand from key trading partners (China as well as some advanced economies) has also affected non-commodity exports. Third, a deterioration in market sentiment versus EMs in the course of 2015 – relating to the China slowdown and Fed rate hike fears – triggered net portfolio outflows (particularly in the summer), contributing to a further tightening of financial conditions in EMs.

Divergence between regions and key EMs has increased These headwinds have not impacted all EMs equally. Latin America, Russia, Central Asia, the Gulf region and Africa have been hardest hit by the drop in commodity prices. Domestic conditions vary as well: economic policies, the scope for stimulus, structural issues, political instability. All these factors help to explain the divergence between regions and countries.

Growth in emerging Asia (around 6%) is slowing a bit, but remains relatively robust. While China is continuing a gradual slowdown, India is growing by ±7.5%, making it the fastest growing emerging giant. Regional growth in emerging Europe has fallen by around 2.5 %points compared to 2014, to -1%. This is driven by Russia (-4%, due to lower oil prices and Western sanctions) and Ukraine (-10%), but Central Europe is doing well helped by the eurozone’s recovery. Latin American growth has fallen by 1.5%-point to around -0.5% this year. Here, the largest economy Brazil (our estimate for 2015 is -3%) was hit by a poisonous cocktail of low commodity prices, political turmoil, weak policies and structural issues.

an EMs face strongest capital outflows since global crisis …

… and BRICs % yoy

USD bn

15

60

10

40

5 20

0 0

-5

-20

-10 -15

-40

06

07

08 China

09

10 India

11 12 Brazil

13 14 Russia

Sources: Bloomberg, Thomson Reuters Datastream, ABN AMRO

15

10

11

12 Equity flows

13

14 Debt flows

15

Source: Institute of International Finance

In Q3-2015, EMs faced with largest capital outflows since global crisis Risk sentiment for EMs deteriorated sharply in the course of 2015, reflecting China-related concerns, falling commodity prices and a looming Fed rate hike. Net portfolio outflows from EMs rose in the summer, contributing to a further tightening of financial conditions. IIF data show that in Q3-2015, net portfolio (equity and debt) outflows amounted to USD 33 bn. This exceeded the levels seen during both the taper tantrum in June 2013 and in late 2014. In October, capital flows to EMs partly returned, after dovish signals from G3 central banks. In November, however, EMs were faced with another wave of outflows (albeit at relatively low levels), driven by the stronger pricing in of a Fed lift-off in December 2015. For 2015 as a whole, EM net portfolio inflows are projected to be the weakest since 2008. The IMF estimates total net inflows in January-November 2015 at USD 44 bn, compared to an average net inflow of USD 270 bn in the period 2010-2014.

… explaining the sharp correction in EM asset prices and currencies The reversal in capital flows in the course of 2015 has gone hand in hand with a sharp correction in EM currencies and stock markets. Our EM currency index dropped to record lows versus the USD, even surpassing the levels seen during the global crisis (chart). This

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Emerging Markets Outlook - The ‘Force’ abates: modest recovery in 2016 – 16 December 2015

partly reflected US dollar strength, bolstered by an improving US growth momentum and rising expectations of a Fed rate hike. Commodity currencies weakened the most versus the USD, including the Brazilian real, the Colombian peso, South African rand, the Malaysian Ringgit, and the Russian rouble. Meanwhile, the underperformance of EM stock markets versus those of advanced economies has widened further in 2015.

… putting pressure on EM currencies and stocks

World trade disappoints in 2015

Index, 2000 = 100

Indices, 2005 = 100

Index vs. USD

300

150

12000

250

160

10000

170

200

150 140 130

8000

120

180

150

190

100

6000

200

4000

50

210

2000

0

220

0

00 05 Commodity index (lhs)

10 MSCI-EM (lhs)

15 EM FX (rhs)

Sources: Bloomberg, Thomson Reuters Datastream, ABN AMRO

110 100 90 80 70 00

03

06

Baltic dry index (lhs)

09

12

15

World trade index (rhs)

Sources: CPB, Thomson Reuters Datastream.

Weak global trade and lower demand from China add to headwinds Weak global trade added to the EM’s headwinds in 2015. Global trade growth has declined in recent years, remaining relatively weak compared to global real GDP growth. This goes hand in hand with the slowdown in global industrial production. All this also translates into a disappointing EM export performance. Growth in EM export volumes fell to 1.1% yoy in January-September 2015, compared to 4.6% in 2013 and 2014. This slowdown was driven by emerging Asia, reflecting weak external demand from China but also from advanced economies like Japan. China’s merchandise imports fell by around 15% yoy so far in 2015, although this contraction is largely explained by the drop in import (including commodity) prices. We estimate that Chinese merchandise imports have contracted by around 5% in 2015 in volume terms.

We expect some EM headwinds to fade in 2016 …, Going forward, we expect several of the headwinds that plagued EMs in 2015 to fade in 2016 (see also our Global economic outlook, Cautious optimism warranted): 1.

Commodity prices. Commodity prices have been falling since 2011, but the pace accelerated in late 2014 and 2015. Many commodity markets continue to be plagued by excess supply. Lower than expected demand from China, disappointing global growth and the increased productive capacity in recent years have created an imbalance between supply and demand in many commodity markets that will take time to disappear. However, as we anticipate that investors’ net short positions will be (partly) closed and that high-cost producers will cut production, we believe commodity markets will have a less negative impact on EMs in 2016 than they did in 2015;

2.

Global trade. Next year, we expect that global trade will benefit from a moderate pickup in global growth and a rebound in global industrial production and manufacturing.

3.

China imports. We also foresee an improvement in China’s imports in 2016, as we expect the country’s slowdown to remain gradual and negative base effects to fade out.

… while currency depreciation will support external adjustment Although the sharp depreciation of many EM currencies versus the US dollar poses inflation risks and raises debt service cost of USD-denominated debt, it also has beneficial effects.

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Emerging Markets Outlook - The ‘Force’ abates: modest recovery in 2016 – 16 December 2015

Depreciation helps strengthen competitiveness, which supports exports, while simultaneously contributing to the squeezing of imports. This mechanism, which has already started working, leads to an adjustment of external imbalances. The chart below shows the current account for five EMs in our so-called fragile six: Brazil, Colombia, Indonesia, South Africa and Turkey (see our September publication, The top six EMs most at risk). The currencies of these countries have all depreciated relatively sharply versus the US dollar. In all cases, the current account deficit has started to come down in the course of 2015.

… but raises debt servicing costs in local currency terms

FX correction helps external adjustment …, Current account balance, USD bn, 4-quarter moving average

External and corporate debt denominated in USD, in % GDP

10 0

-40

30

-50

25

-60 -10

-70

-20

-80 -90

-30 -40 11

12 Colombia Brazil (rhs)

13

14

15

Indonesia Turkey (rhs)

20 15 10

-100

5

-110

0

16 South Africa

Source: Thomson Reuters Datastream

External debt*

Non-financial corporate debt

Sources: BIS, EIU.

* Estimated maximum dollar share

We expect emerging markets’ growth to modestly recover in 2016-17 Tighter credit conditions will remain a headwind, but EMs should benefit from fading headwinds (stabilisation of commodity prices, pick-up in global trade and fading import weakness in China) and currency depreciation, which will support external adjustment. All in all, we expect growth in EMs to stage a modest recovery (in line with global growth), from 3.7% in 2015 to 4.2% in 2016 and 4.6% in 2017. Still, divergence between regions/countries will remain high:

Emerging Markets: Economic growth forecasts % yoy

2013

2014

2015*

2016*

2017*

6.5

6.3

6.1

6.0

5.8

- China

7.7

7.3

7.0

6.5

6.0

- India

6.9

7.3

7.5

7.5

7.5

Emerging Europe

1.7

1.3

-1.0

1.7

2.4

1.3

0.6

-4.0

0.5

1.5

Latin America

2.4

1.2

-0.4

0.4

2.4

- Brazil

2.7

0.2

-3.0

-2.0

1.5

Emerging markets

4.6

4.4

3.7

4.2

4.6

World

3.0

3.1

2.9

3.3

3.4

Emerging Asia

- Russia

Source: ABN AMRO Group Economics.

-

* Forecasts for 2015-2017 are rounded

Emerging Asia will continue to outperform other regions, but the gradual slowdown will continue, driven by China. India will still be Asia’s fastest growing giant. We see some room for improvement in export-oriented economies, as external demand should strengthen on the back of improving world trade.

-

The outlook for emerging Europe has improved. Following a deep crisis, we expect Russia to grow modestly this year. The economies in Central Europe should continue to propel ahead, supported by the Eurozone’s continuing recovery. In the case of

5

Emerging Markets Outlook - The ‘Force’ abates: modest recovery in 2016 – 16 December 2015

Turkey, there is not much scope for acceleration, given its external and political fragilities.

-

We anticipate that Latin America will see a revival of exports, which will kick-start a cautious economic recovery in 2016. However, persistent structural problems and the impact of restrictive economic policies will continue to prevent an exuberant recovery.

Risks still clearly tilted to the downside Still, we see a number of risk factors that could derail our base scenario of a modest economic recovery in emerging markets in 2016/2017.

1)

Fed rate hikes. With the Fed lift-off expected in December, we expect 75 bps in additional rate hikes by the Fed in 2016. This could trigger a new wave of portfolio outflows, contributing to a further tightening of financial conditions in EMs. This risk could be even greater should the Fed hike faster than expected and/or if the lift-off would trigger a sharp increase in bond yields in advanced economies. For several EMs, this risk is mitigated by a large share of FDI in external financing (e.g. Brazil) or a sizeable stock of foreign exchange reserves (e.g. China, energy exporters).

2)

High private debt levels ... There has been a rapid accumulation of private debt in EMs since the global financial crisis. This debt load is concentrated in emerging Asia and mainly driven by China, but other countries in Asia (e.g. Korea, Hong Kong, Singapore, Thailand, Malaysia) and elsewhere (e.g. Brazil, Chile, Turkey) also have high debt levels. Such high debt burdens could prove to be a drag on the economy, certainly in the case of rising interest rates, as they could depress domestic demand and may lead to repayment problems for borrowers and a deterioration of asset quality for banks.

3)

… and high dollar debts. In the case of US dollar denominated debt, risks are exacerbated by the weakening of EM currencies versus the dollar. BIS data show that the level of USD denominated corporate debt in countries like Turkey, Russia, Mexico and Indonesia correspond to 10% of GDP or higher (see chart on previous page).

4)

Hard landing China. Our base scenario assumes an ongoing gradual slowdown of China’s economy in 2016-17. Obviously, given the country’s relevance in the global economy, global trade and commodity markets, a faster-than-expected slowdown would pose a key risk to our EM outlook.

5)

Global trade remains weak. Should global trade (including imports from China) continue to disappoint, this could jeopardise our projection of a pick-up in EM exports.

6)

No stabilisation/rebound of commodity prices. Sustained excess supply in commodity markets and/or disappointment on the demand side could mean commodity prices stay lower for longer or fall even further. That would pose greater risks for commodity exporters.

7)

Geopolitical risks. Our base scenario could be threatened by geopolitical risk factors, given the wide range of potential triggers: unrest in the Middle East, tensions between Russia and Ukraine/Turkey/NATO, political risks in Europe (rise of anti-establishment parties, Brexit, independence movements) and Latin America, conflicting claims in the South Chinese Sea etcetera.

In conclusion In summary, in our base scenario we expect emerging markets to stage a modest recovery of GDP growth in 2016-17. However, against the background of the looming Fed rate hikes – the first in almost a decade –, high EM debt levels and ongoing uncertainty regarding China’s transition, we feel that risks are still clearly tilted to the downside. That said, there is also a small possibility of positive surprises coming from the EMs. These could stem, for instance, from a stronger-than-expected pick-up in global growth and EM exports or an overall improvement in risk sentiment benefiting commodity prices and EMs more generally.

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Emerging Markets Outlook - The ‘Force’ abates: modest recovery in 2016 – 16 December 2015

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