The emerging market slowdown: don't expect a quick recovery

That big grinding sound in the global economy is the emerging market world shifting down to a lower gear. The stream of news this year suggests that emerging economies are recording their lowest rates of growth since the global financial crisis.

Of course, EMs have weathered slowdowns and even crashes before, and generally come back strongly. More disturbing about the conjuncture is that the difficulty in generating strong growth seems as much structural as it does cyclical, suggesting that expansion will remain modest even if domestic policy is loosened and external conditions become more supportive. The structural weaknesses vary within the EM world, but they add up to a situation where getting growth over the next five years is a much bigger challenge than coping with the headwinds over the next few months.

Real growth is slowing in the EMs. The tracker run by the consultancy Capital Economics (see chart above) suggests that emerging economies are expanding at an annual rate of less than 4 per cent for the first time since 2009, and before that the first time since the 2001 US recession and the Argentine debt default.

Neither is this purely a China phenomenon: other big EMs are also struggling to expand. Brazil continues to grapple with above-target inflation and its attempts to display fiscal consolidation to regain policy credibility. Russia's geopolitical and debt woes are reducing growth in the central and eastern Europe region as a whole, if only by dragging down the average. Some of this reflects the knock-on effects of the Chinese slowdown, of course, but that merely underlines that the medium-term growth prospects of many EMs are weak and vulnerable to shocks.

As Capital points out, the previous two big growth slowdowns, in 2001-2002 and 2009, were sharp demand-driven shocks creating output gaps that were fairly promptly reversed as policy was loosened and global demand recovered.

This time round there is less evidence that a lot of slack exists. Unemployment has not risen much in the EMs, and while headline inflation has fallen sharply over the past year because of the drop in the global oil price, core inflation rates in EMs have moved much less. The potential for aggressive monetary easing to offset the impact in many EMs is thus limited.

To start with the biggest beast, China has started to loosen monetary policy in response to its slowdown. But how much effect that will have on boosting growth in the short to medium term is unclear. China's structural problems include massive overinvestment and consequent excess supply capacity and high corporate leverage. A lower interest rate environment will help deleveraging, but it may also make the excess capacity problem worse.

China's transition from an investment to a consumption-led growth model is likely to take a long time. Moreover, while the transition is taking place and even afterwards, the much-vaunted benefits for other EMs in exporting consumer goods to China will probably take a long time to materialise. For the moment, the effects of China's slowdown have already spread across the rest of the EM world: exports to China from most emerging economies are contracting in value terms. But even if Chinese demand recovers, the fact that more of its supply chain will be contained within its own economy will reduce a source of external demand for other EMs.

Similar if less dramatic versions of the Chinese capacity and leverage problems also occur in other EMs, particularly in Asia. Countries such as Malaysia have high levels of private sector debt which may also take a long time to work off, particularly if an appreciating dollar and rising US interest rates make servicing that debt more expensive. Bond yields in most EMs have risen in recent months despite growth slowing and flat-to-falling inflation, which will add to the challenge. Corporate profitability has also been weak for a while, suggesting that companies will want to retrench rather than invest even if interest rates are lower.

Elsewhere in the EM world, the familiar warnings still hold sway - given the recent imprimatur of the IMF - that underlying growth appeared to slow several years ago. Efforts at structural improvements to reverse the decline have been feeble and sporadic - and even if the pace of such reform picks up, liberalisation and other disruptive measures tend to be contractionary in the short run.

Brazil continues to lead by bad example in having fostered structural supply-side shortcomings that prevent demand-side tools being able to restore growth. Despite its economy slowing, more tightening of monetary and fiscal policy look likely, as authorities struggle to reduce inflation - and inflation expectations - below target and induce confidence in the country's fiscal sustainability.

In the near term, the performance of the EM world as a whole will depend most on China and whether the Chinese economy reacts to policy stimulus rather than entering a prolonged adjustment accompanied by sub-par growth. But even as and when it does recover, the likelihood of a sharp bounce-back of the kind that accompanied the last two big EM slowdowns is disturbingly low.

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