The Bank for International Settllements (BIS) Annual Report

BIS 78th Annual Report

BIS 78th Annual Report
III. Emerging market economies
30 June 2008

Growth in emerging market economies (EMEs) last year once again significantly exceeded that in the rest of the world. Foreign currency inflows were large, reflecting continued growth in current account surpluses and capital inflows in 2007. Nevertheless, the potential knock on effects of financial market turmoil in the major centres increased the risk of a slowdown in EMEs. At the same time, recent increases in headline inflation have caused inflation targets to be breached in many EMEs, reflecting the impact of steep increases in oil and food prices. As in the advanced industrial economies, these conflicting forces have created a major dilemma for monetary policy. Efforts to resist currency appreciation have introduced additional complications, having been associated with a sharp increase in foreign reserves and in credit growth in a number of EMEs.

Developments in the advanced industrial economies could also pose major challenges. First, a pronounced slowdown in the United States would hurt the EMEs which, although remarkably resilient so far, still depend significantly on external demand. Second, tighter conditions in global financial markets could constrain EMEs with large current account deficits, particularly those relying on more volatile portfolio financing. Countries heavily dependent on cross-border bank borrowing could also be especially vulnerable.

HIGHLIGHTS

Uncertainties about the prospects for the emerging market economies (EMEs)
deepened during the period under review. Although growth in EMEs last year
once again significantly exceeded that in the rest of the world, the potential
knock-on effects of financial market turmoil in the major centres increased the
risk of a slowdown in EMEs. In line with this, equity prices in many emerging
markets, which rose strongly for much of 2007, weakened in the early part of
2008, suggesting lower growth expectations. At the same time, further steep
increases in oil and food prices added to inflationary pressures. As in the
advanced industrial economies, these conflicting forces have created a major
dilemma for monetary policy. A further complication is that many countries
are still resisting currency appreciation. Moreover, with the fall in US rates,
interest rate differentials over dollar rates have widened. This has attracted
additional capital inflows, making the task of monetary tightening in the face
of rising inflation more difficult.
Developments in the advanced industrial economies could also pose
major challenges. First, a pronounced slowdown in the United States would
hurt the EMEs, which, though remarkably resilient so far, still depend
significantly on external demand. Second, tighter conditions in global financial
markets could constrain EMEs with large current account deficits and those
relying on cross-border bank borrowing.


MACROECONOMIC DEVELOPMENTS

Growth in the EMEs as a whole was 7.7% in 2007, above the already rapid
average pace of 7% recorded during 2003–06 (Table III.1). Current projections
envisage growth of around 6.7% in 2008, notwithstanding the sharp slowdown
in the industrial world foreseen in the consensus forecast.
Continuing the pattern of recent years, the key driver of economic growth
in all EME regions continues to be domestic demand, reflecting strong private
consumption and investment spending (Graph III.1). Net exports have also
made positive contributions to growth in China and other emerging Asia, but
negative contributions in Latin America. How far growth in the emerging
economies will be supported by robust domestic demand in the context of a US
slowdown is a key question that will be addressed later in the chapter. In brief,
risks to growth for EMEs are on the downside.
With growth strong, CPI inflation rose sharply in the course of the past
year in all major EME regions (Graph III.2). The pickup in inflation, which was
particularly apparent in the second half of 2007, was greatest in Asia (with year-on-year inflation accelerating from less than 3% to over 6% between late
2006 and April 2008), followed by Latin America (from 4.1% to 5.7%). Recent
increases have brought inflation above formal or informal 2008 targets in 15
out of the 17 largest EMEs that announce such targets, and indeed well above
informal targets in China and India. In Korea and Mexico, inflation has recently
remained above the inflation target or hovered close to it. Large increases
in inflation have also been recorded in many other countries, including Chile,
the Czech Republic, Indonesia, the Philippines, Russia, South Africa and
Thailand. In Brazil, where inflation has been within the target range, sharp
rises in headline inflation (actual and forecast) raised concerns that the
midpoint of the target range would be exceeded at the end of 2008.
Inflation forecasts for 2008 rose during 2007 in Asia, Latin America and
other emerging markets (Graph III.2), ending an extended period in which
such forecasts had generally remained stable. These higher forecasts probably
reflect an interaction between rising wage inflation, expectations of further
increases in the prices of food and energy, and demand pressures.
Wage trends in EMEs are hard to assess because of the lack of
internationally comparable data. There are, however, signs of more rapid wage increases in some of the largest EMEs. For example, annual wage growth has
been in double digits in China, averaging 14.4% in 2001–06 and rising to
17.7% in the third quarter of 2007. This reflects not only demand pressures
feeding into wage claims, but also structural changes, including rising minimum
wages and new labour legislation that has strengthened contractual rights for workers. In India, some private sector surveys indicate double digit increases
in private sector salaries in recent years, and large adjustments to the salaries
of government employees have also been proposed.
The upward trend in headline inflation may well be expected to persist.
One reason is that increases in food and energy prices, which account for
much of the rise in headline inflation in many countries, show no consistent
signs of abating (see below). Another is that the underlying rate of inflation,
as measured by core inflation, has also accelerated (Graph III.3). Core inflation – that is, excluding food and energy prices – rose in all EME regions starting
around the second half of 2007, with a median contribution to headline
inflation of 2.5 percentage points early in 2008, against a headline inflation
figure of 6.3%.
A number of indicators suggest that demand pressures have also played
an important role in EME inflation. While simple correlations need to be
interpreted with caution, inflation has tended to be higher in countries where
the level of real output has been above estimates of trend (Graph III.4, lefthand
panel) or where GDP growth has been faster (not shown). Inflation has
also tended to be higher in countries with rapid credit growth and where the
exchange rate has appreciated by less (Graph III.4, centre and right-hand
panels). As discussed below, an easy monetary policy stance and large-scale
intervention in foreign exchange markets appear to have contributed to these
outcomes.