Collateral damage: the emerging market growth story under threat

The Donald Trump presidency remains an unknown quantity. As Reserve Bank of Australia deputy governor Guy Debelle told a conference last week, the only certainty is uncertainty and if you’re going to write volatility insurance charge a high price for it.

Ripple effects seem an inadequate description of a Trump takeover of the Oval Office, more like tidal waves. And they’ll still be huge when they reach emerging Asia and the emerging world more generally.

"If banks do continue to shrink balance sheets in emerging Asia it would seem likely that funding retrenchment would impact growth in the region."
Andrew Cornell, Managing editor, BlueNotes

The Institute of International Finance posted an alert “our measure of daily portfolio flows to emerging markets fell sharply over the past week, with the 7-day moving average declining to its lowest level since the China worries-induced sell-off in August 2015. This downward shift in flows has triggered a reversal alert that began on November 11”.

Will Trump truly be an isolationist? If he is, investors are likely to reduce their commitment to emerging markets. And this would be just the latest, indirect but seismic, jolt to those parts of the world which actually offer the best chance of significant growth.

The IIF monitors capital flows into emerging markets as these flows fund the investment required for economic growth – almost by definition such economies can’t fund their own growth. The returning down trend then is bad news for emerging market growth.

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Just why is complicated but two significant reasons are regulatory changes and a more general retreat to home markets by providers of capital.

Under the latest wave of global regulatory change for the banking system, the Bank for International Settlements (BIS) and its agencies have focused on total bank capital and risk weightings. The net impact has been higher levels of capital for banks – to make them safer – and changes to the amount of capital required to be held against different class of loans – risk weights.

That has translated to banks generally reducing risk weighted assets, particularly in sectors and geographies where risk weights have been increasing – including emerging markets.

Global investor State Street notes “regulations stemming from the 2008 financial crisis, coupled with historically low interest rates and slow rates of growth in the global economy have constrained the ability of many US and European banks to perform their traditional roles as market makers which has impacted broader market liquidity conditions.

Other forces also contribute to banks and other investors withdrawing from emerging markets. Greater risk aversion in general or a determination the rewards in higher risk emerging markets during recent volatility are not sufficient is clearly evident.

But a study by the IMF concluded regulation is a driving force.

“This paper shows the importance of regulatory tightening in accounting for the post-crisis sluggishness in international banking,” it concluded. “In particular, our empirical analysis suggests that regulatory tightening can explain half of the decline in the foreign lending-to-GDP ratio between 2007 and 2013.

“Regulatory changes in home countries seem to have been more important than changes in host countries to explain this decline; also regulations targeted at banks’ international operations seem to have mattered more than general financial regulatory changes.”

This phenomenon was also seen in Europe in the years after the financial crisis as the need to recapitalise had the perverse effect of draining funds from investment and hence throttling back Eurozone growth.

If banks do continue to shrink balance sheets in emerging Asia – where banks are the source of the majority of funding – it would seem likely that funding retrenchment would impact growth in the region.

Overlay the Trump wild card and the effect could be amplified. A Bloomberg analysis based on Bank of America Merrill Lynch survey data flagged such a possibility:

“The (emerging market) asset class is perhaps the one that will react most violently to the outcome, given the trade rhetoric expressed by both candidates. In other words, expect emerging equities to hurt the most if Trump wins,” Bloomberg forecast. Offsetting that however was the prospect of bargain buying.

We can take recent announcements by this bank, ANZ, as indicative of a much broader trend in the region. At ANZ’s September year profit announcement, the bank spoke of a portfolio rebalancing underway, with retail and commercial risk weighted assets (RWAs) increasing 6 per cent and institutional RWAs reducing 15 per cent. Institutional lending declined $A21 billion.

“Focus on growing RWA in higher returning segments improved,” ANZ said with institutional margins, excluding the markets, improving 13 basis points.

Previously the bank’s head of institutional banking Mark Whelan has expanded on this rebalancing, noting the bank was concentrating on business in Asia where there was an acceptable return on investment and a focus on customers who had deeper relationships with ANZ.

For shareholders, this makes perfect sense. Banks need to focus on return on equity. Where the cost or quantity of equity rises, more discipline is required to obtain the return. The hurdle for lending to emerging markets becomes higher.

That’s not the only hurdle being raised. Regulatory focus on money laundering and other illicit activities such as financing terrorism, a greater scrutiny of the end customers, also reduces the ease with which banks can lend into emerging markets.

A further impact on emerging market economic growth is the tougher constraints being placed on the remittance market where flows typically run from advanced economies to emerging ones as expatriates send funds back home.

The Trump ascendancy has already caused scrutiny of the huge remittance market from the US to Mexico.

The American Banker noted Trumps pledge to suspend remittances to Mexico if it did not agree to cover the estimated $US10 billion cost of building a border wall, a market worth about $US24 billion in 2016, according to the World Bank.

Whether Trump could actually do this is yet another huge question up for debate but there has already been considerable discussion of the effective tightening of financing via more regulation of correspondent banking arrangements.

“Amid regulatory and profit pressures, banks have cut activities that are deemed too costly to be commercially pursued,” noted Jaime Caruana, General Manager of the BIS, recently.

“The reduction in correspondent banking relationships and cross-border remittance services, for instance, raises concerns that some parts of the world are being shut out of these formal financial channels.”

What then for the emerging middle class, particularly in Asia, the highest potential consumers in the world? One offset is the flood of liquidity into emerging markets from central bank quantitative easing as actually driven down margins for lenders, turning them away from emerging markets. Tighter liquidity could push margins back up and encourage banks to return.

This chart from the Harvard Business Revenue tells a story of more than a thousand words: globalisation, which is in essence growing international trade in goods and services coupled with more immigration, has contributed significantly to the wealth of middle Asia.

There has been drastically less benefit for the lower middle class of Europe and the US – Brexiteers and Trump voters included. (Although it should be noted in aggregate, even for these disgruntled cohorts, it has still been positive).

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Do we now then face a period where a conspiracy of global forces, including more rigorous regulation with a consequent response by banks to reduce risk weighted assets and an anti-globalisation agenda by western governments, drives down growth in international trade?

The Financial Times was not optimistic in its editorial on trade: “But one thing is clear: with global trade already weak, there are serious risks to international commerce from the accession to power of a US president with such a simplistic analysis of the world.”

There is less appetite for risk in emerging markets which have provided growth. The price of that risk is higher. Funding for investment in the region is retracing. And so the wealth impact on the Asian middle class – the hope of the consuming class – will undoubtedly be significant.

Andrew Cornell is managing editor of BlueNotes.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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