Emerging markets outlook, October 2023
Although shifts in supply chains away from China have boosted some emerging markets, these countries may soon need to look toward domestic demand to drive economic growth as the rest of the world potentially deals with a slowdown.
Emerging market economies have held up better than their developed economy peers. For example, with a reading of 52.7, the emerging market composite purchasing managers’ index remained firmly in expansionary territory in August, while the developed market composite PMI slipped below the critical threshold of 50 (figure 1).1 Earlier this year, numerous emerging market economies benefitted from strong demand in the rest of the world and the relatively high commodity prices that accompanied that demand. A handful of countries have also benefitted from changes in global supply chains, as many businesses look to shift some manufacturing away from China. As economic growth potentially slows down in the developed world, emerging market economies may need to rely on domestic demand to fuel growth.
Fortunately, after recessionary periods, domestic demand appears to be turning the corner in parts of Latin America and Eastern Europe. Those regions have also seen some of the most dramatic declines in inflation,2 which is beginning to usher in more accommodative monetary policy. This should support domestic demand growth. Monetary policy in other regions is unlikely to be as accommodative either because inflation was more benign to begin with or because inflation continues to run hot.
Changing supply chains creates opportunity
Prior to the pandemic, the United States placed sizable tariffs on a wide array of goods imported from China. Since then, additional restrictions have been placed on trade between the two countries.3 The share of US imports from China fell 7.2 percentage points between 2017 and 2023 year to date.4 That is equivalent to roughly US$225 billion, a sizable sum for most emerging market economies.
So far, the countries that have proven to be best positioned to replace China have been Mexico, Vietnam, Taiwan, and India, which have collectively added 5.1 percentage points to their share of US goods imports (figure 2).5 Although such changes certainly present an opportunity for these countries, the total benefit is likely smaller than the exported values would indicate. The trade data tracks the price of goods sold between two countries without accounting for the value added by other countries before the exchange is measured. This means that China could provide 99% of the value added in a good sold from Vietnam to the United States, while the trade data attributes the entire sale to Vietnam.
Recent research shows that these four countries that have gained share of US imports have also seen their imports from China rising.6 Although this could be coincidental, it suggests that the value these countries are adding to exports to the United States is smaller than the export values would indicate. However, there has also been substantial investment in some of these countries, which suggests that more value may be added domestically in the future. For example, foreign direct investment in Vietnam jumped by US$2.5 billion year to date in August when compared to a year earlier.7 Nearly half of that increase came from China.8 Mexico had also seen a flurry of FDI from China at the end of 2021 and through much of 2022.9 However, those investment flows have slowed to a trickle since then.
Supply chains are not moving just because of the China-US relationship. The pandemic exposed weaknesses in how global trade is conducted. For example, supply chains into Japan have also shifted away from China, albeit to a lesser extent. China’s share of Japan’s goods imports fell 1.6 percentage points between 2019 and 2023. The largest gains were in Taiwan and Indonesia, which picked up 1.0 and 0.7 percentage points, respectively.10 To be clear, the shift in supply chains has been slow, and so far, the benefits are relatively muted. However, over time, these countries are likely to increase the value they add to exported goods, which will boost their manufacturing capacity and competitiveness.
Inflation improvements are a bright spot
Most emerging market central banks have succeeded more at taming inflation than their developed market peers. Countries in the Americas and Europe have faced some of the strongest inflation and have, therefore, seen some of the fastest declines in price growth. For example, year-over-year headline inflation has come down by more than eight percentage points in Poland, Hungary, and Czechia over the last six months (figure 3).11 Although headline inflation remains above 10% on a year-ago basis in Poland, its central bank cut its policy rate in September for the first time since April 2020. Polish inflation appears to be slowing faster than year-ago numbers indicate, as core inflation over the last three months was just 5.4% on an annualized basis.12
Poland followed some central banks in Latin America that had already cut rates. Brazil and Chile managed to get inflation down to 4.6% and 5.3%, respectively, in August.13 Both countries had inflation in the double digits earlier in the cycle. Such strong disinflation has allowed their central banks to cut rates, though both their policy rates are above 10%, indicating a relatively tight monetary policy stance.
In much of Africa and parts of the Middle East, central bankers have more work to do. Turkey, Egypt, and Nigeria are all struggling with exceptionally high inflation, with Turkish inflation nearing 60% from a year earlier in August.14 Turkey’s central bank raised rates by 16.5 percentage points between May and August alone.15 However, this still leaves inflation-adjusted interest rates highly accommodative, suggesting the central bank may need to raise rates more substantially before inflation comes back down to earth.
Conversely, Asian central bankers have had a comparatively easier time with inflation in this cycle. Although inflationary pressures picked up across the globe, they were more muted in Asia as its postpandemic reopening occurred at a more gradual pace. For example, the most recent readings of inflation were below 3% in Malaysia, Taiwan, Thailand, and Vietnam.16 China’s inflation even briefly dipped below zero percent in July. Even so, only China and Vietnam have cut their rates. Meanwhile, despite relatively favorable inflation numbers, Thailand hiked rates in August.17
Moving forward, emerging markets may have a more difficult time getting inflation under control. Higher crude oil prices are raising costs for consumers. India had watched its inflation rate tumble from 7.8% in April 2022 to 4.7% one year later.18 Since then, higher food prices forced inflation to jump to 6.8% in August, which is above the central bank’s target. India’s rebound in inflation came before the recent rise in oil prices, suggesting that inflation could rise even further. The same is likely true for other emerging market economies, especially those that are net importers of oil.
Domestic demand needed to fuel growth
Nearly every economy, including the most developed ones, faces the same constraints when it comes to stimulating domestic demand. Specifically, large fiscal support during the pandemic has exacerbated debt positions, which will make it more difficult for policymakers to provide government stimulus should economic growth falter. Elevated interest rates add to this challenge. Some countries likely have more fiscal space than others. For example, windfall revenue from high oil prices gives some oil-exporting countries a bit more room to maneuver in the near term. Notably, Saudi Arabia’s replenished coffers have allowed for a substantial rise in government-funded capital expenditures.19 However, for most economies, policymaker support will be in short supply.
Countries in Latin America and Eastern Europe are likely best positioned to usher in the strongest growth in consumer spending. Part of this is because their economies had been mired in recession earlier and are now poised for a recovery. For example, real consumer spending in Chile, Czechia, and Hungary contracted for at least three consecutive quarters before returning to modest or flat growth in the second quarter.20 These economies have also seen dramatic reductions in inflation, which should strengthen purchasing power and consumer spending as we move to the end of the year. Plus, the lower rates that accompany lower inflation should ease some of the downward pressure on durable goods spending.
Asia’s emerging market economies have held up better recently, suggesting that a pickup in consumer spending will be less apparent than in Latin America or Europe. Domestic demand in these economies was already growing at relatively strong rates in the first half of this year. For example, real consumer spending in India, Indonesia, Malaysia, and Thailand accelerated in Q2.21 Because their central banks did not need to hike rates as much as other emerging market central banks, monetary policy will likely play a more limited role in supporting domestic demand moving forward.
Unfortunately, domestic demand in Africa faces more challenges as inflation has proved more difficult to subdue. High rates of unemployment continue to weigh on South Africa’s economy. Plus, inadequate infrastructure has limited the growth prospects of South Africa and Nigeria’s mining and manufacturing sectors, placing another weight on government revenue and exacerbating unemployment.22
Emerging market economies that have tamed inflation will be in the best position to keep economic activity moving in the right direction while the rest of the world struggles to avoid recession. Even so, policymaker support for more economic growth is likely to be in short supply as bloated government budgets and the risk of inflation limit intervention. Although the external sector is unlikely to be a source of support as the global economy slows, shifts in supply chains should give an added boost to some Asian emerging markets as well as Mexico.