By Fernando Losada
Fixed-income investors often divide emerging markets into commodity exporters and commodity importers. We think this overlooks an important reality: commodity wealth is not the sole—or even the most important—driver of EM performance.
It’s certainly true that a decade of increases in energy, metal and agriculture prices have swelled national incomes in commodity-rich countries in Latin America, Europe, Africa and Central Asia. Display 1 shows what some of those countries’ real gross domestic incomes would have been without the terms-of-trade shock caused by the commodity boom (the dark green bar) and what it was when accounting for it (the light green bar).
As expected, commodity-rich countries such as Venezuela and Russia saw a boost in their terms of trade—the relative difference between import and export prices—and, consequently, their real income. Turkey, South Korea and other commodity-dependent countries, on the other hand, took a hit.
Yet our research shows that being a commodity producer didn’t guarantee improved credit fundamentals or stronger growth during that time. In fact, some of the commodity “winners” are actually worse off today. Many commodity importers, on the other hand, weathered the storm and saw their economies strengthen.
Why didn’t the last decade’s unprecedented commodity boom have a uniform impact across emerging markets? The reason is simple: Only a handful of commodity-rich countries took advantage of the windfall and the fiscal flexibility it provided to push reforms that would improve their growth potential and diversify their economies away from excessive dependence on commodities.
Instead, many boosted spending on social programs, public sector wage hikes and other initiatives designed to gain political favor. When commodity prices stabilized, they were left with gaping fiscal holes and little political room to cut expenditures. In short, some of the commodity “winners” ended up on the losing end.
Struggling with the Commodity Boom
Venezuela may be the best example. The energy price increases helped boost gross domestic income in the country by a whopping 240% over the past decade. But the government squandered most of the windfall, leaving the country just as vulnerable now as it was in 2003.
The story was similar in Ukraine, a large metals producer, where the potential positive impact of the commodity boom was neutralized by capital flight and increased spending by the governing elite.
Ukraine may be an extreme example, but it’s worth pointing out that broad indices of government effectiveness and accountability declined over the past decade across all regions. In fact, the strength of institutions deteriorated more in commodity exporters than commodity importers.
Put another way: Too many commodity exporters behaved as if the commodity windfall were permanent. This can be seen in EM public finances. While government balances have improved across emerging markets over the last decade, they deteriorated, on average, among primary commodity exporters (Display 2).
Sound Policies Key to Success
On the other hand, commodity boom “losers”—or net importers of commodities—behaved in a more disciplined manner on the whole. For example, the run-up in commodity prices forced Turkey—a net commodity importer—to make policy adjustments to cushion the blow of higher food and energy costs. Today, the country runs a more responsible fiscal policy than it did in 2003.
Among the resource-rich countries, only Kazakhstan, Mexico, Colombia and Indonesia demonstrated an ability to improve fundamentals over the last decade of commodity price gains.
In our view, strength in EM economies ultimately boils down to smart policy choices. We found that countries that embraced prudent macroeconomic management and pushed through unpopular reforms saw the quickest rise in real incomes and the biggest improvements in credit quality, irrespective of commodity wealth.
That’s important for investors to know, because it’s the countries that were most proactive on the reform front who are best positioned to grow and prosper—especially if commodity prices remain stagnant or decline in the next decade.
Our findings also underscore just how important it is to be selective when investing in EM fixed income. Emerging markets are not a homogenous asset class, and commodities, while an element in overall performance, are certainly not the main drivers of economic success.