Financial markets love to come up with snappy acronyms – you have all heard of BRICS, but there are many others, with the “fragile five” being the latest.
The BIITS - Brazil, India, Indonesia, South Africa and Turkey - constitute an important group. They all have large populations, they have been growing strongly for much of the last decade, and increasingly they have become surrogates for the developing world in big global meetings such as the G20.
These attributes, being large and with good growth momentum, have made them investment magnets. And because they have all opened their economies to more capital inflow over the last decade, investors have been quick to shift money into those markets as a consequence of the low interest rates in the US and Europe. Their markets are not completely open to “hot” money, but open enough for the inflows to have caused problems.
Some of the problems have been because exchange rates have been bid up. This causes all the problems we understand well in Australia from any extended period when the currency rises relative to our trading partners. A number of these economies have also suffered as their companies have borrowed in dollars to invest locally in the hope that they can grow fast enough to pay off the debt. A sudden fall in the exchange rate, if capital rushes out, can make it impossible to pay down the debt, so companies collapse.
So these economies have faced problems as their currencies have been bid up, making their businesses less competitive, and face risks (are fragile) when capital flows out.
Will capital flow out? Is the concern real? All of these issues are up for debate when the group of 20 finance ministers and central bank governors meet in Sydney this weekend.
Most focus has been on monetary policy in the US. The US has kept its interest rates very low for a long time. As a result investors have looked to other markets to generate better returns, or have been willing to lend to companies in those markets. As the US economy improves, and the US Federal Reserve starts to withdraw support from the market, money is likely to flow back from the emerging markets to the US.
This readjustment of the US economy and its interest rates will cause waves through all financial markets, and the biggest effects are likely to be in the emerging markets because they are small relative to the flows in and out of the US market. Clearly we are in for a period of uncertainty.
Governments in these small economies will be particularly concerned. While all these countries are developing, they all have many poor people whose situation could be made worse by an economic jolt, and their institutions are not as strong as others.
Turkey and India are struggling with political tensions, Brazil is in recession, and Indonesia and South Africa have to deal with a slowdown in commodity prices at the same time as potential financial shocks.
The picture is not completely grim. All are much better managed than they were a decade ago. They have flexible currencies and solid reserves. They should all continue to grow solidly over the medium term. Longer term investors are likely to take advantage of any sharp fall in prices to invest more in those countries: short term investors are more likely to panic.
From the G8 to the G20
One of the important consequences of the financial crisis was to make it clear that the developing countries were important to the world economy. The G8, focussed on the North Atlantic economies, ceased to be the focus of political solutions, and was seen as the source of economic problems.
By contrast the developing economies performed much better, and effectively supported the G8 countries. China in particular was an important source of savings. As a result, and partly due to Australia’s prodding, the G20 became the locus of much decision making as it was necessary to involve the strong economies in the search for solutions.
The change seems permanent. No one doubts that gradually the weight of the developing countries will increase in global decision making, in the IMF and everywhere else. Change might be slow, and Europe still overweighted, but change will happen.
We can expect tensions at the G20 between the traditional powers and the new ones. Some of it is likely to be precisely around the issue of how the US manages its exit from quantitative easing. The highly respected head of the Indian central bank, Raghuram Rajan, has already sharply criticised the US: expect more of the same.