30 Dec 2015
EM risk: Slowdown, not meltdown in 2016 – Goldman Sachs
FXStreet (Delhi) – Research Team at Goldman Sachs, suggests that like most investors, we are worried about debt overhang in the EM economies, particularly in China where the debt-to-GDP ratio has increased by nearly 100 percentage points since the global financial crisis.
Key Quotes
“Even after excluding China, EM debt-to-GDP has climbed from pre-crisis levels of less than 100% to record highs above 110%. While it is normal for debtto-GDP ratios to rise as financial markets deepen, this post-crisis acceleration of credit growth rightly raises concerns about the burden of this debt on growth. Now that it has become clear that commodity prices will remain ‘lower for longer’, and furthermore that China’s economy will continue to slow due to structural reforms, these concerns have taken on added urgency.”
“The full effects of lower-for-longer oil prices will continue to be felt for some time in the oil producing economies. But in EMs like Russia and Mexico, where currency depreciation has helped absorb the terms-of-trade shock, the remaining adjustments to government and private-sector balances should be correspondingly less painful. We are more concerned about places with pegged exchange rates (such as Nigeria and Saudi Arabia), where the burden of adjustment falls more squarely on government fiscal balances, domestic households and corporates (and in the limit, the exchange rate peg may itself be at risk). And, of course, pressures on both groups of EMs will rise materially in the event that oil prices fall further – to the $20/bbl downside risk scenario outlined by our Commodity team.”
“We think these forces are likely to keep EM growth at a sub-par level, but an EM meltdown is not inevitable because the nature of the EM challenge is different. Much of the EM borrowing in this cycle is denominated in local currency (of course, there are pockets of hard-currency exposures); hence, EM economies are less vulnerable to the traditional crisis model involving the ‘original sin’ of hard currency sovereign borrowing. Reserve buffers are also more significant this time around. This means that the real challenge is navigating a poor growth outlook with large relative price shifts, and the institutional capacity to do this.”
Key Quotes
“Even after excluding China, EM debt-to-GDP has climbed from pre-crisis levels of less than 100% to record highs above 110%. While it is normal for debtto-GDP ratios to rise as financial markets deepen, this post-crisis acceleration of credit growth rightly raises concerns about the burden of this debt on growth. Now that it has become clear that commodity prices will remain ‘lower for longer’, and furthermore that China’s economy will continue to slow due to structural reforms, these concerns have taken on added urgency.”
“The full effects of lower-for-longer oil prices will continue to be felt for some time in the oil producing economies. But in EMs like Russia and Mexico, where currency depreciation has helped absorb the terms-of-trade shock, the remaining adjustments to government and private-sector balances should be correspondingly less painful. We are more concerned about places with pegged exchange rates (such as Nigeria and Saudi Arabia), where the burden of adjustment falls more squarely on government fiscal balances, domestic households and corporates (and in the limit, the exchange rate peg may itself be at risk). And, of course, pressures on both groups of EMs will rise materially in the event that oil prices fall further – to the $20/bbl downside risk scenario outlined by our Commodity team.”
“We think these forces are likely to keep EM growth at a sub-par level, but an EM meltdown is not inevitable because the nature of the EM challenge is different. Much of the EM borrowing in this cycle is denominated in local currency (of course, there are pockets of hard-currency exposures); hence, EM economies are less vulnerable to the traditional crisis model involving the ‘original sin’ of hard currency sovereign borrowing. Reserve buffers are also more significant this time around. This means that the real challenge is navigating a poor growth outlook with large relative price shifts, and the institutional capacity to do this.”