2018 - 2019 Edition of Citi Perspectives for the Public Sector

30 Building Emerging Market Resilience to New Economic Challenges Changes in the global economy Three global, ongoing economic developments are of particular significance to EMs: 1. Sustained U.S. growth, coupled with a rising Federal Funds Rate. Beginning in 2009, unprecedented low interest rates in mature economies propelled yield-hungry funds into EM economies. In response to the global slowdown, EM governments, corporates and households borrowed heavily to maintain growth and meet their budgetary needs. This drove EM debt levels to record highs relative to these countries’ combined GDP. Rising U.S. interest rates are now attracting marginal investment dollars away from, or out of, EMs. At the same time, these rising interest rates also make USD-denominated loans more expensive for borrowers to service. EM economies thus face a “double whammy”: pressure on their foreign exchange reserves and weakening local currencies, relative to the USD, combine with higher financing costs to constrain their fiscal room for maneuver. 2. Episodes of volatility in currency and commodity markets. Since the U.S. Federal Reserve first floated the idea of ending post-crisis stimulus in 2013, EM currency markets have endured waves of abrupt currency volatility. In the year leading up to the Fed’s first interest rate hike in late 2015, a range of EM currencies fell against the U.S. dollar: for example, the Chinese yuan slid 4%, and the Brazilian real dropped 47%. Following the Fed’s hawkish statement to the market in June 2018, EM currency volatility spiked again. U.S. dollar volatility, doubts about global growth in the event of worsening trade relations, and geopolitics are also transferring periodic volatility into commodities markets, including those of oil, gas, copper and other traded metals. 3. Divergent growth trajectories among major economies. The differences in mature economies’ interest rates also reflect these countries’ divergent growth expectations. Relative to a few years ago, when rising tides appeared to be lifting most ships, economic expansion is now increasingly concentrated in certain countries and regions. For example, in late June Citi revised down its expectations for Eurozone growth from 2.5% to 2.1%, noting slowdowns in consumer and corporate spending, while in the U.S., retail spending helped second quarter growth reach 4.1%. As a result, the fortunes of smaller EMs might depend on whether or not they have strong ties to larger, fast-growing countries. Political and environmental trends There are a number of exogenous dynamics exacerbating EM financial risks. Two of the most important of these, in terms of their potential impact on EM economies, are: 4. Politicians in both mature and emerging economies are renegotiating the terms of international trade. Both politicians and the public in many countries are reconsidering the norms and expectations of the past. The apparent political turn towards protectionism in several countries is a critical new development. In an extreme manifestation of this risk, high tariffs and the imposition of other barriers could abruptly dislocate supply chains and damage global growth prospects. Consequently, even countries not party to a trade war could easily suffer collateral damage. 5. Natural disasters are causing increasingly large economic losses. Now more than ever, economies are exposed to natural disaster risk because of increasing asset concentration (in ever-larger cities) and climate change-driven intensification of weather events. In 2017, total losses due to natural disasters reached $337 billion, the second highest value on record, only 43% of which was insured. Moreover, annual losses in low-income countries, including many EMs, are on average four times larger than in wealthy economies. 2 When countries are unprepared for disasters, the ensuing rehabilitation efforts derail government budgets and exhaust available capital. Post- disaster spending is also less efficient and less transparent in countries without disaster recovery strategies. When countries are unprepared for disasters, the ensuing rehabilitation efforts derail government budgets and exhaust available capital. 2 Munich Re (2017) “ Hurricanes cause record losses in 2017 — The year in figures, ” https://www.munichre.com/topics-online/ en/2018/01/2017-year-in-figures; International Monetary Fund Blog (2016) “ Small States Confront Big Challenges with Natural Disasters and Climate Change, ” https://blogs.imf.org/2016/12/22/small-states-confront-big-challenges-with-natural-disasters-and- climate-change/