The real big risk for emerging markets this year lies in surging real interest rates.
The global cheap money era is ending, leading to an increase in the cost of capital. But demand in the developed world and China isn’t strong enough to lift prices for manufacturers, service providers and commodity suppliers.
The real interest rate for corporations is the difference between bond yields and changes in the prices they get for their goods, as measured by producer price inflation. On that gauge, rates in emerging markets are now sharply higher than they were between 2010 and 2012.
This matters, because real interest rates have a strong effect on investment sentiment. In the aftermath of the global financial crisis in 2009, the gap between emerging market bond yields and changes in producer prices widened to 8 percent. Investment in major Asian and Latin American economies promptly slumped by 6 percent. When quantitative easing in the West pushed real interest rates below zero in 2010, private investment in emerging markets zoomed 20 percent.
As real rates climb again, the fate of about $6 trillion in annual private investment in Asia and Latin America is in doubt. The simple average real cost of capital in 12 major economies of these two regions was 5 percent in 2013, already a sharp increase from minus 1 percent in 2011. If bond yields keep rising and producer prices remain subdued, the universe of profitable investment opportunities in emerging markets will shrink even further.
That will be bad news for a global economy struggling to escape long-term stagnation. There is hardly any sign of a revival in corporate investment appetite in the West. Private consumption, too, is lacklustre. A drop in emerging markets’ contribution to global demand won’t help it revive.
The threat might ebb if emerging markets cut their domestic interest rates. But with economic and political risks on the rise, jittery investors might not accept lower yields. The other solution is for rich nations to start importing more, and pay more for their imports. If that happens, the real cost of capital for companies in developing countries will fall. For now, though, that’s a distant hope.