The latest decision by the Federal Reserve to pare down its monthly asset purchases by another $10 billion might turn out to be one of the few sure things in what promises to be a very delicate and unpredictable year.
The prospect of rising yields in the U.S., and, more generally, of improving growth prospects in advanced countries poses a serious threat to the carry strategies of the last few years and is bound to significantly increase volatility in 2014. In addition, any significant slowdown in economic conditions in China will spill well beyond its borders.
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Nowhere will these challenges be felt more severely than in developing economies. Years of access to cheap credit in the aftermath of the financial crisis and, in some cases, of an over-reliance on commodity demand, have allowed many governments to pursue short-term populist policies, while removing much of the urgency to implement key structural reforms necessary to achieve sustainable growth. As a result, according to the Conference Board, gains in labor productivity in emerging markets slowed to just 3.5 percent in 2013, after averaging 5.5 percent between 2000 and 2009. This slowdown was even more dramatic in major countries like India and Brazil.
Ironically, for those who well remember the stern criticism leveled at advanced countries for their lax policies in the lead up to the financial crisis, it now appears that the recent growth in emerging economies has also been largely driven by increases in leverage. The average public and private saving rate is now as low in Latin America as in the previously profligate euro zone, and the familiar and unmistakable signs of a demand boom driven by consumption and housing are now appearing in many regions. Add in sizable current account deficits in several countries and small, but growing, budget gaps and we have plenty of reasons for concern.
The recent International Monetary Fund growth projections for emerging and developing countries remained favorable, pointing to a slight increase in GDP growth to 5.1 percent in 2014, and an average rate of nearly 5.5 percent for the rest of the decade. But the headline numbers can be deceptive. Exclude massive China, and expected growth in all other developing economies falls to just 4.0 percent for 2014 and 4.5 percent for 2015.
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Reality will be much grimmer for many, particularly in Latin America and Eastern Europe, even if the IMF estimates turn out to be accurate. For example, GDP growth was projected at 3.5 percent in Turkey, 2.8 percent in South Africa, 2.3 percent in Brazil and only 2.0 percent in Russia. Throw in the prospect of ongoing civil unrest, plus currency and other business risks, and it is hard to see the short-term appeal in these markets.
Unfortunately, there is also a good chance that actual performance will fall short of these predictions, perhaps even significantly so. China largely remains in control of its own destiny. Elsewhere, much will depend on the response of financial markets and local governments to changes in US monetary policy. Still, the movement towards firmer policy stances that started last year in countries like Brazil and India and, is now clearly quickening will eventually impair growth.
It is true that based on fundamentals there should be little reason to expect a massive and widespread reallocation of capital away from emerging economies in 2014. After all, notwithstanding recent tapering efforts, U.S. policy remains strongly accommodating by historical standards, and yields here are still not expected to rise much this year. Slack monetary policy also lingers in the euro zone and Japan and is, if anything, tilted towards more, not less, accommodation. Finally, growth prospects in much of Asia and Sub-Saharan Africa remain appealing, particularly for those with a long-term perspective.
But capital markets are unlikely to be that sanguine. The shift towards some reallocation is unmistakable and policy makers are clearly nervous about the size of this coming tidal wave. Last summer's swoon offered both a useful warning for many and an opportunity for governments to test different policy responses. Faced with the threat of short-term capital outflows, policy makers are likely to respond first with some increase in interest rates, but should ultimately allow their currency to depreciate.
This policy response should mitigate the immediate damage to economic growth and ensure a faster recovery in the event of a capital flight. Unfortunately it can no longer prevent one from occurring in the first place. The spotlight is now firmly on emerging economies and many are not ready for the increased scrutiny. An ensuing financial panic that reverses the portfolio flows of recent years has now become a distinct possibility. And at times like these, investors are often not very discriminating.
— By Joao Gomes
Joao Gomes is the Howard Butcher III professor of finance at UPenn's Wharton School, and a faculty affiliate of the Penn Wharton Public Policy Initiative. Follow Penn Wharton PPI on Twitter