From feast to famineHow emerging markets are creating a global saving shortfall

UBS Asset Management

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Executive summary

His conclusion at the time was that one of the reasons for why global interest rates are so low is because of an excess of desired saving over desired investment emanating mainly out of China and other emerging markets and oil producers like Saudi Arabia.

Over a decade on from this thesis much has changed. Emerging markets are no longer flush with cash as evidenced by the shift in current account balances from surplus to deficit, the collapse in foreign exchange reserves, and the shrinking of sovereign wealth funds. More specifically, Brazil’s public debt risks spinning out of control; Russia and South Africa are both in deep crisis; and China is ploughing through $US100 billion of foreign reserves a month.

Against this backdrop, the demand for global savings has continued to rise driven mostly by a tripling in the value of investment in emerging markets in the past decade.

On balance, we find that Bernanke’s “global saving glut” has significantly declined. We estimate that by 2020, the $US416 billion global saving surfeit will turn into a $US460 billion global saving shortfall, a turnaround of $US875 billion.

Will this savings gap put upward pressure on global interest rates? For now, central banks will remain a dominating force in suppressing the price discovery of interest rates. This means investors need to accept that volatility will remain, non-fundamental drivers of markets will become more important, and a greater portion of their portfolio should be allocated to tail risk hedges.

But quantitative easing is a temporary solution to the wrong problem. Eventually free market forces will reign and the famine in global savings will eventually put upward pressure on global interest rates and perpetuate the trend to trade protectionism and parochial policy-making.

Tracey McNaughton Executive Director Head of Investment Strategy April 2016

In 2005, Ben Bernanke, former Chairman of the US Federal Reserve, discussed the macroeconomic implications of global flows of saving and investment under the rubric of the “global saving glut”.

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Introduction

The last interest rate tightening cycle in the US started in June 2004 when the Federal Reserve raised official interest rates from 1.0 percent to 1.25 percent. The tightening cycle lasted two years and left the official rate at 5.25 percent by June 2006. During this time, despite the 425 basis point lift in cash rates, the yield on the 10-year Treasury bond did surprisingly little — rising just 60 basis points. The behaviour of the bond market was so unusual it was labelled by the then Chairman of the Federal Reserve, Alan Greenspan, as “a conundrum”.

In response, Ben Bernanke, then a member of the Board of Governors of the Federal Reserve, put forward a thesis for why longer dated interest rates around the world, not just in the US, were low 1.

Bernanke argued that a glut of global saving emanating predominately out of Asian and Middle Eastern developing economies was helping to fund the US current account deficit. Between 2005 and 2009, the US current account deficit had increased cumulatively to $US3.3 trillion, or 1.3 percent of world GDP. Over the same time period the current account surplus of China, the Rest of Asia and the Middle East rose to $US3.6 trillion, or 1.4 percent of world GDP.

1 Bernanke, 2005

As can be seen in Chart 1, the US current account deficit from 2005 to 2009 absorbed all the surplus saving from China, the rest of Asia, and the Middle East.

Two key reasons were identified as to why the developing economies as a whole became large net lenders of capital rather than borrowers on international financial markets.

First, in response to the number of financial crises developing economies experienced in the 1990s (including Mexico in 1994, the Asian financial crisis in 1997–98, Russia in 1998 and Brazil in 1999), reserves or 'war chests' were built up. An increase in foreign exchange reserves necessarily implies one or a combination of a shift toward a current account surplus, an increase in capital inflows, or a reduction in capital outflows.

A second factor identified was the sharp rise in the price of oil. This resulted in the collective current account surplus of the Middle East and Africa rising by more than $US40 billion between 1996 and 2003.

Chart 1: Current account — Percentage of cumulative world GDP, 2005–09; Bars are $USbn

Source: McKinsey

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According to the balance of payments identity:

Current account = Capital account

Current account = (private capital inflow–private capital outflow) + change in FX reserves

Rearranging we obtain:

Net capital flow = change in FX reserves – current account (1.1)

The three components of the identity are jointly determined. In the case of China, for example, the most recent observations have currency reserves falling by $US512 billion in 2015. Since China has a current account surplus of around $US600 billion, the implied capital outflows must have been over $US1 trillion.

Another first principle worth pointing out is the relationship between saving, investment and the current account. We know that:

Saving = Investment

At the national level and in an open economy, however, saving does not always equal investment. Rather:

Saving = Investment + Current account

Rearranging:

Current account = Gross Saving – Gross Investment (1.2)

Whenever a country’s gross national saving falls short of its gross investment, it has to borrow the difference from abroad to fund its investment requirements. This net borrowing occurs through capital inflows and foreign investment. In this case, the country would be running a current account deficit and a capital account surplus of equal magnitude. If gross saving exceed gross investment, the opposite would be true.

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The first section of what follows will focus on how emerging economies, in the last decade, have moved from being net creditors to the world to net debtors. The analysis will look at how current account balances have changed and the role played by oil prices in influencing foreign exchange reserves.

The second section will look at investment trends and therefore the demand for global savings.

The final section will make some conclusions about the saving — investment imbalance and identify the implications for investors.

"The US current account deficit from 2005 to 2009 absorbed all the surplus saving from China, the rest of Asia, and the Middle East."

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Global saving

The role of emerging markets in boosting global savings

In the wake of the decision by the US Federal Reserve to undertake quantitative easing in November 2008, the US dollar weakened considerably, especially against emerging market currencies. The South African rand, for example, rose 42 percent in the two years between the start of 2009 and the end of 2010 while the Brazilian real rose 39.3 percent.

At one point, a cup of coffee in Sao Paulo cost more in US dollar terms than it did in Oslo, Tokyo, Sydney or Zurich. According to Deutsche Bank, a 5 star hotel room in Sao Paulo in 2012 was 138 percent of the price (in USD terms) of a 5 star room in New York 2.

At the same time, the lower growth, lower yielding environment created a spill-over effect, forcing investors to move out the risk-spectrum and seek out higher yielding investments in ever more exotic places. A dollar-denominated government bond issued in 2012 by Zambia, a copper-rich country with an average GDP per person of only $US1,700 a year, offered just 5.4 percent interest; even so, it was 24 times oversubscribed as rich-world investors clamoured to buy.

2 “The Random Walk: Mapping the World’s Prices 2013”, Deutsche Bank Markets Research

Net private portfolio capital inflow into emerging markets topped nearly $US5 trillion in the four years between 2010 and 2013, exceeding the total inflows in the 17 years between 1990 and 2006 3. Even though the current account surplus position of emerging markets was shrinking at this time (Chart 4), the size of portfolio capital inflows was such that foreign exchange reserves increased (as per equation 1.1).

G20 foreign exchange reserves peaked globally in August 2014 at $US8.2 trillion. These reserves are heavily concentrated among the emerging markets where they were built up heavily in the wake of the 1997 Asian financial crisis — 81 percent of G20 reserves are with emerging G20 central banks. China alone represents a massive 47 percent of the G20 total.

3 “The Random Walk: Mapping the World’s Financial Markets 2014”, Deutsche Bank Research

Chart 2: Emerging market debt

Source: IMF, IIF

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"At one point, a cup of coffee in Sao Paulo cost more in US dollar terms than it did in Oslo, Tokyo, Sydney or Zurich."

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How oil boosted global saving

The fact that oil is priced in US dollars means that if the dollar falls, the US dollar price of oil tends to rise. This can be illustrated with a simple example. Assume a one-to-one exchange rate between the US dollar and the Canadian dollar. If the price of oil is $US50 per barrel, the cost of importing a barrel from Canada is $US50. If the US dollar depreciates to 0.9 Canadian dollars, the US dollar price for a barrel of oil goes up to $US55.56.

It wasn’t just US quantitative easing that was helping to keep the price of oil elevated, Saudi Arabia was also playing its role as the swing oil producer keeping the supply in balance with China-driven demand.

Between 2011 and 2014, the price of oil averaged close to $US90 per barrel. The current account surpluses of oil and gas exporting nations, accounting for 26 percent of all emerging market GDP and 21 percent of external bonds, rose significantly as petrodollar revenues surged.

Much of this excess saving found its way into Sovereign Wealth Funds (SWF), a relatively new creation among commodity-producing countries (two-thirds were incepted inside the last 15 years).

According to the Sovereign Wealth Institute, oil exporting countries currently hold about $US4.3 trillion in SWF assets. Of this, 73 percent comes

from oil and gas revenues. Between 2009 and 2014, oil exporters accumulated as much as $US1.8 trillion of SWF assets.

The impact of higher oil prices was particularly evident in Russia where 70 percent of export revenue comes from oil and gas. Other countries such as Nigeria and Venezuela also benefited from the windfall. In Saudi Arabia, the world’s largest oil producer, the current account surplus hit a peak of 23.7 percent of GDP in 2012.

The role of emerging markets in decreasing global savings

Strong currencies meant imported inflation among emerging economies was kept low which also meant monetary policy was free to be accommodative relative to history. Official interest rates in Brazil, for example, were cut to a low of 8.75 percent in 2009 after being as high as 19.75 percent just four years earlier.

The easy monetary conditions facilitated by strong currencies lead to a surge in corporate debt among emerging market companies. In 2007 emerging market corporate debt levels stood at $US7.1 trillion. By 2015 the amount of emerging market non-financial corporate debt outstanding was $US23.2 trillion. A large proportion of this debt, 22 percent, was issued by the energy sector. The emerging markets most exposed to this rise in corporate indebtedness are Brazil, Russia, Turkey, China, India and Indonesia.

Fiscal policy too was relaxed. Brazil, for example, initiated fiscal programs in housing and bank lending equivalent to 27 percent of GDP between 2007 and 2014. This ultimately led to public debt levels climbing from 38 percent of GDP in 2009 to 60 percent today. Emerging market government debt levels in general have doubled between 2007 and 2015 to $US9.6 trillion.

The decision by the US Federal Reserve to end quantitative easing in October 2014 had significant ramifications for a world that had for so long relied on a weaker US dollar. The tide began to go out on emerging market currencies and with it the benefits of low inflation and low interest rates.

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Chart 3: Sovereign wealth funds — Assets under management

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G20 emerging currencies have fallen significantly against the US dollar since. The Russian ruble, the Chilean peso, and the Brazilian real have each lost around a third of their value against the USD since the middle of 2014.

Rapidly declining emerging market currencies are now putting upward pressure on inflation. Many emerging market central banks are responding by increasing official interest rates and selling foreign exchange reserves to defend their currencies. Brazil has increased interest rates back up to 14.25 percent and plans to tap its foreign exchange reserves to fight the deepest recession since records began in 1901 and prevent a surge in unemployment.

Emerging markets had net capital outflows of $US735 billion in 2015, up from $US111 billion in 2014. Outflows are expected to continue in 2016 with Turkey, Brazil and South Africa being the most vulnerable. The end of China’s “one-way-bet” on its currency together with easing capital controls has fuelled an outflow of capital from China and hence has put downward pressure on its foreign exchange reserves.

About half of emerging market economies are commodity exporters. Among the largest are Brazil (iron ore, and soybeans), Chile (copper), Indonesia (nickel, aluminium and coal), and Russia (oil and gas). Slower economic growth out of China, weak commodity prices, and sluggish global trade are reasons to suggest emerging market current account balances will continue to deteriorate for some time to come.

Chart 4: Emerging market current account balance

Source: Bloomberg, IMF

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Emerging market capital outflows combined with the expectation that current account surplus’s will continue to shrink, will put even further downward pressure on foreign exchange reserves (as per equation 1.1).

How oil is shrinking global saving

The policy decision by Saudi Arabia in 2014 to increase production in order to squeeze out other marginal oil producers has led to the collapse in US dollar oil prices. Softening growth in China is also influencing the price of oil. Oil prices have fallen by 70 percent from their peak in June 2014.

Oil exporting nations are consequently feeling the pinch of less oil revenue coming into their economies. For the first

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Chart 5: Petrodollar exports

Source: BNP Paribas

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time in 18 years, petrodollar recycling in financial markets has gone into reverse (Chart 5). Rather than being exporters of savings, oil exporters have become capital importers.

Saudi Arabia’s fiscal position has deteriorated dramatically. Three years ago its fiscal surplus was 12 percent of GDP. Today the Saudi’s are running a deficit of 15 percent of GDP — its largest deficit ever. Funding this deficit is a problem when your tax base is very narrow. Oil revenues make up 90 percent of fiscal revenue leaving just 10 percent coming from non-oil revenues. Making matters even more challenging, food and fuel are heavily subsidised.

To help address its funding problem, Saudi Arabia, like many other oil exporters, have been forced to tap into their sovereign wealth funds and foreign exchange reserves to help fund their rapidly rising fiscal deficits. As Chart 6 shows, the oil price Saudi Arabia needs to come out even on their fiscal accounts is significantly higher than the current spot oil price.

Broadly, fiscal balances among emerging economies have fallen from an average surplus

of 1.2 percent of GDP in 2007 to an average deficit of 4.1 percent in 2015. Overall public debt has risen from an average of 37 percent of GDP in 2007 to 44 percent in 2015.

For the oil-exporting emerging markets (Russia, Qatar, Saudi Arabia, UAE) the deterioration has been most pronounced. For non-oil commodity-exporting emerging markets (Brazil, Chile, Colombia, and Peru) deficits have widened by more than a percentage point and debt has risen above 50 percent of GDP in Brazil and Colombia.

Several commodity-importing economies entered the emerging market growth slowdown with deficits above 4 percent of GDP and debt above 50 percent of GDP (Egypt, Hungary, India and Poland) and their debt and deficits remain elevated despite consolidation efforts.

It appears likely that the savings famine in emerging markets will continue for some years to come. Age-related government spending will increase while the transition of the Chinese economy, the worlds’ largest saver, toward consumption will put downward pressure on household savings.

Assuming China follows the path of other Asian economies, we can expect its savings rate to fall significantly in the years ahead after already falling from a peak of 51.9 percent of GDP in 2008 to 47.8 percent in 2015.

"It appears likely that the savings famine in emerging markets will continue for some years to come."

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Chart 6: Fiscal breakeven oil price—Saudi Arabia

Source: Bloomberg

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Global investment

As Chart 7 shows, global investment was on a downward trajectory between 1989 and 2002 where it hit a low of 22.4 percent of global GDP. It grew strongly in the lead-up to the global financial crisis after which it collapsed in 2009. World investment has since recovered and is now on an upward trajectory once again.

The expectation is that the upward trend in investment will continue. The focus for the G20 is shifting toward increasing investment. In the absence of effective monetary policy to generate self-sustaining economic recoveries, pressure is rising on national governments to add to aggregate demand by increasing infrastructure spending.

On current GDP growth projections, our expectation is the value of global investment will double from $US12.4 trillion in 2006 to $US23.6 trillion by 2020. Much of this will be driven by emerging markets where we expect the value of investment to reach $US15.9 trillion by 2020, triple the 2006 level.

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Chart 7: World investment

Source: Bloomberg

Globally, about 1.5 million people are added to the urban population every week. The world’s major emerging markets — Brazil, China and India — all need to increase their spending on infrastructure in order to keep abreast of the demand driven by this growth. Emerging market economies are currently running sizeable infrastructure deficits. In Brazil, 86 percent of roads are unpaved. Although it is home to at least 20 million people, Beijing only has 527 kilometres of subways — less than Tokyo's 2,500 kilometres and New York's 3,342 kilometres. In Mumbai, the number of train commuters is rising at three times the rate at which rail capacity is growing.

Many developed market economies are also suffering an infrastructure crisis, but one caused by decades of underinvestment and poor maintenance. The US alone is in desperate need of infrastructure spending. According to the American Society of Civil Engineers (ASCE), the US earns a D+ for its infrastructure. ASCE estimates 32 percent of major roads in the US are in poor or mediocre condition while the US Federal Highway Administration estimated a 24–46 percent increase in annual capital outlay is needed for substantial improvement.

The collapse of the I–35 West Mississippi River Bridge in Minneapolis seven years ago had been deemed structurally deficient as early as 1990. Since 2000 there have been 20 bridges collapse in the US compared with six in India. In total, ASCE estimates a total investment of $US3.6 trillion is needed to bring the infrastructure back up to standard.

"In Brazil, 86 percent of roads are unpaved."

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As depicted in equation 1.1, Chart 8 summarises how the decline in current account balances and foreign exchange reserves implies that emerging markets are now net capital debtors to the rest of the world. Given the increase in political risk, slowing global trade and the high level of corporate indebtedness, it seems unlikely that net capital flows will move into positive territory anytime soon. A continued deterioration in the current account positions of many emerging market economies implies a further depletion in foreign exchange reserves.

This decline in global savings means little if it is accompanied by an equal decline in global investment. For the world as a whole, however, gross investment as a share of GDP is expected

to rise. As a result, the gap between desired global saving and desired global investment is expected to shrink to $US240 billion by the end of 2016. This is down from the $US416 billion gap recorded in 2006. This has principally been driven by a $US7.7 trillion increase in desired investment mainly from emerging markets and is consistent with our expectation that emerging market current account positions will once again slip into deficit territory (as per equation 1.2).

Importantly, by 2020, we estimate Bernanke’s $US416 billion saving surfeit will turn into a $US460 billion saving shortfall. This $US875 billion turnaround will have significant implications for investors over the coming years.

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Chart 8: Emerging market net capital flows

Source: Bloomberg

The savings feast provided by emerging economies that Ben Bernanke pointed to as being a driver behind the fall in global interest rates at the start of this century has turned into a saving famine.

Conclusion

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Implications for investors

Unconventional monetary policy has laid the groundwork for a world where central banks can step in and flood the financial system with liquidity to keep interest rates low. The current quantitative easing efforts of Europe and Japan alone are together supplying the world with $US1.7 trillion in capital each year. So while ever quantitative easing policies are in place, the natural forces of supply and demand for capital will be suppressed.

The problem with quantitative easing, however, is that it is a solution to the wrong problem. After experimenting with quantitative easing in earnest over the past eight years, it seems apparent that all it has managed to achieve is shift the debt-burden from the private sector wallet to the public sector purse. This is fine if the problem was a blockage in the supply of credit. Unfortunately, the problem lies more in a lack of aggregate demand.

Whilst the private sector is certainly now able to contribute to aggregate demand, a more precautionary attitude means there is less willingness to do so in the wake of the financial crisis, despite a lift in asset prices. This means filling the hole in aggregate demand will require an increase in government spending.

Given this, we believe that ultimately quantitative easing will give way to fiscal stimulus as has been the case in Japan, albeit more than a decade too late.

Two scenarios are possible in the years ahead — either we move closer to the Japanese model whereby the debt is monetised by the central bank purchasing government bonds with newly minted money; or the natural forces of supply and demand will be allowed to operate to economically ration the provision of capital to the market.

Either scenario is not particularly appealing. While it does seem likely that central banks will continue to play a dominating role for now in suppressing price discovery of interest rates, ultimately, free market forces will reign. Hence, the implications under both scenarios are relevant to today’s investors.

Implications under scenario 1

1. Investment fundamentals take a smaller roleThe rise of central banks in influencing the flow of capital implies the need for fundamental investing to be complemented with an increased focus on non-fundamental factors like sentiment and momentum. The traditional view of supply and demand fundamentals will still be a necessary, but no longer a sufficient, indicator for the future cost of capital.

The Japanese Government bond market, for example, has been over–valued on fundamental grounds for over a decade. And yet a fundamental investor who sold 10–year Japanese bonds in 2006 on the expectation that the yield would rise would have lost close to 50 percent of their investment by 2016.

The ability to pre-empt central bank moves will be key under this scenario. Associated with this is what the central bank reaction function looks like and indeed how it evolves.

What role will global market conditions play? In the case of the Federal Reserve, we know it will be “data-dependent” but to what extent will it also be “market-dependent”?

Historically, the Fed has eschewed talk of global conditions, focussing instead on the domestic economic environment. Recent guidance from the Federal Reserve, however, is increasingly making reference to key words as “global”,

“China” and “dollar” suggesting the Fed’s reaction function is indeed evolving to match the dynamic market conditions.

This implies a reflexive relationship between the market and central bank. In the same vein as Keynes’ famous beauty contest — the central bank is responding to a market that is responding to the central bank.

2. Increased market volatilityIn this environment, market volatility is likely to rise. Investors will not only be relying on the interpretation of central bank guidance, a qualitative indicator, but this guidance itself can be subject to error or mis-step. This is particularly the case for central banks and governments who are still learning how to communicate with the market. Think China. Think the surprise yuan devaluation on 11 August 2015.

3. Tail risk hedgingIn an environment of heighted market volatility driven by forces that are difficult to predict, hard to interpret and subject to error, investors need to make an allocation in their risk budget for tail risk hedges. These hedges should be designed to work when the market is taken by surprise by the actions of national governments or central banks.

"The Japanese Government bond market, has been over-valued on fundamental grounds for over a decade."

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Of course, all investment risk cannot be hedged. But if more of an investors’ risk budget is allocated to risk hedging activities, less is allocated to alpha-generation. The implication, therefore, is that returns will be lower.

Implications under scenario 2

1. Upward pressure on global interest ratesThe fundamental shortfall of global saving to fund global investment will only increase in the years ahead. As the world continues to age, household savings will decline. The associated rise in age-related government spending will similarly strain government budgets. Moreover, the single biggest contributor to global saving, China, will see saving rates decline as it transitions toward a consumption-driven economy and the rise in the welfare state leads to a decline in household precautionary saving and a rise in fiscal spending.

This means that when central banks do step away from quantitative easing, the underlying forces of supply and demand for capital will re-exert themselves, putting upward pressure on global interest rates as a result. Indeed, in a reversal of Greenspan’s 2005 conundrum, the term premium built into long term bond yields can be expected to rise back up to more normal levels of around 50 basis points from a current level of near zero.

2. Rise in trade and labour protectionismIn a world where there is a growing shortage of global savings, funding national current account balances will become increasingly competitive.

Scarcity of global capital may lead to governments having an incentive to increase home country bias in both physical and financial portfolios. If current account deficits become more difficult to fund, governments will be incentivised to encourage economic growth based more on import-substitution.

Import-substituting growth has in the past been understood to be poor policy as it gives no consideration to different countries’ comparative advantage and the absence of economies of scale makes it deeply inefficient. In the late 1960s, Latin America had 90 firms producing cars!

It already seems apparent that protectionism is on the rise, partly in an effort to create a supportive environment to boost import-substituting activities like domestic manufacturing. Adding fuel to this protectionist trend is the rise in parochial policy-making driven by growing geopolitical risk, and the depletion in political capital and rise in inequality after the financial crisis.

"In the late 1960s, Latin America had 90 firms producing cars!"

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The UK referendum on EU membership, the Scottish and Catalan referendums on independence, the rise in extremist, non-mainstream voter support, and the growing number of coalition governments are just some examples of this trend in action.

Protectionism around the supply of labour is also raring its head. The European refugee crisis and the rise in

terror-related activity is weakening public support for the free movement of people across EU borders. The free movement of labour is one of the founding principles of the EU. Similarly in the US, the degree of voter disenchantment with regard to immigration and free trade, as revealed in the 2016 presidential race, is threatening to sway Democratic policy support for the Trans-Pacific Partnership free trade deal between the US and Asia-Pacific.

References

Bernanke, B. (2005). "The global saving glut and the US current account deficit", Remarks by Governor Ben S. Bernanke at the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia, April 14.

Bernanke, B (2015). “Why are interest rates so low, part 3: The Global Savings Glut”, Brookings Institution, April 1.

Bernanke, B (2015). “Germany’s trade surplus is a problem”, Brookings Institution, April 3.

Bouissou, J. (2013). “Mumbai’s rail commuters pay a high human price for public transport,” Guardian Weekly (London), October 29.

Lubin, D. (2016). “China and emerging markets: Broken growth model?”, Citi GPS: Global Perspectives and Solutions, January.

McKinsey Global Institute (2010). “Farewell to cheap capital? The implications of long-term shifts in global investment and saving”, December.

Sanyal, S. (2013). “The Random Walk: Mapping the World’s Prices 2013”, Deutsche Bank Markets Research, April 3.

Sanyal, S. (2014). “The Random Walk: Mapping the World’s Financial Markets 2014”, Deutsche Bank Markets Research, April 1.

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