Bank for International Settlements warns of emerging market risks

Economists and foreign investors may have overestimated the potential economic output of a quintet of Latin American countries by 2 percentage points, leading to the possibility of sharp financial outflows when reality sinks in.

Separately, “massive borrowing” by emerging market companies has also left them vulnerable to funding reversals if and when investor sentiment towards EMs reverses.

These are among the warnings from the Bank for International Settlements, commonly known as the central bankers’ central bank, in its annual report, releasedon Sunday.

Amid slowing economic growth across much of the emerging world, the BIS says that a “moderation” of growth from the very high rates seen in recent years is “probably unavoidable”.

However, it warns a slowdown could “cast doubt” on the underlying economic strength of emerging market economies for three reasons.

Firstly, it says the high commodity prices and strong capital flows witnessed in recent years “may have led to overly optimistic estimates of potential output”.

The past decade has seen the largest gross foreign investment as a percentage of recipient economies’ GDP for more than a century, the BIS says, with these inflows fuelling domestic credit and asset price booms.

These financial booms, allied to elevated commodity prices, have boosted output, but the Basel-based bank warns “it would be unwise to treat these effects as permanent”.

“Therefore reversals in these factors could well result in disappointing growth outcomes,” the bank concludes.

It argues that estimates of the difference between actual and potential output, ie the output gap, that correct for the cyclical effect of higher commodity prices and capital flows “indicate that traditional measures could have overestimated potential output by around 2 per cent on average across Brazil, Chile, Colombia, Mexico and Peru since 2010”.

Secondly, the BIS says that credit booms and real exchange rate appreciation in emerging markets have historically coincided with a shift of resources from the tradable to the non-tradable sectors of the economy.

“Such resources misallocations can substantially weaken productivity growth and require painful adjustment,” it warns.

Given the financial booms of the past 10-15 years, and the fact that the median real effective EM exchange rate hit a 30-year peak in mid-2013 (although it has now fallen back towards its long-term average), the bank fears a repeat.

Thirdly, the BIS fears that the “heavy debt service burdens” arising from the credit boom could weigh on medium-term growth.

According to the bank, the combined debt of the government and non-financial private sectors across emerging markets is 50 per cent higher in relation to GDP than at the time of the 1997 Asian financial crisis.

This growth has been concentrated in the private sector, where borrowing has jumped from 60 per cent of GDP in 1997 to 120 per cent as of last year.