Why Emerging Markets Are Getting Crushed

An expected Fed shift, China’s slowdown, and middle-class unrest spark an investor exodus
Damage at a bank branch after demonstrations in São Paulo on July 26 Photograph by Miguel Schincariol/AFP/Getty Images

For years developing countries have been thrice blessed. First, near-zero interest rates in the U.S. drove investors into bourses from Mumbai to Mexico as they searched for higher returns. Next, China emerged as the trading partner of choice as it gobbled up Indonesian palm oil, Cambodian hardwoods, and Brazilian iron ore. Finally, with the exception of the Middle East, the politics of most emerging-market countries were stable.

The blessings have run out. In the eight weeks through July 17 investors pulled $40.3 billion from emerging-market bond and equity funds amid signs that the U.S. Federal Reserve may start scaling back its stimulus effort. At roughly the same time, massive demonstrations in Turkey, Brazil, and Egypt shook the foundations of power in those countries. Adding to the turmoil is a slowdown in China that’s affecting exports, from coal to copper to potash.

These three challenges could feed off one another and have the potential to set back some emerging-market economies well into 2014. Developing nations deprived of cheap funding from the capital markets are punished far more during downturns than rich nations with extensive social safety nets like the U.S. or Europe.

Poorer nations depend on jobs and wage increases generated by growth to mitigate social tensions, says José Ángel Gurría, secretary-general of the Organisation for Economic Co-operation and Development. “The needs are much more elementary and brutal,” says Gurría, a former Mexican finance secretary. Families live with “vermin because they don’t have cement on the floor. This isn’t the problem the middle class in the Netherlands face.”

A report by Nomura International, citing protests in Brazil and Turkey, says 11 other countries—including China, India, Russia, Argentina, and Venezuela—face the risk of civil unrest in the short to medium term. The middle classes spawned in these countries since 2000 are frustrated with corruption. “If you lift your people out of extreme poverty, it’s not like they’re going to say, ‘Great, now we’re all set. We don’t want anything else,’ ” says Jim Yong Kim, president of the World Bank.

Despite the pockets of strength, emerging-market investors have headed for the exits. The MSCI Emerging Markets Index has fallen about 9.6 percent since May 21, the day before Fed Chairman Ben Bernanke said the central bank might taper off its $85 billion in monthly bond purchases if U.S. joblessness keeps dropping. Brazilian stocks have slid 13.7 percent since then, while the real has hit a four-year low. Stocks in Turkey and China have posted double-digit declines. The MSCI World Index of advanced nations, in contrast, has dropped less than 1 percent.

In the Asian crisis of the 1990s, most of the countries involved were big exporters to the U.S. and Europe. Today many of those economies depend on China to buy their commodities. That reliance could hamper them for years. The International Monetary Fund cut its global growth forecast on July 9 for the fifth consecutive time. It said a leveling off in China and the risk of money returning to developed countries present new challenges to the emerging-market nations that, with China, have propelled the world economy.

In June, Indonesian President Susilo Bambang Yudhoyono stared down demonstrators and cut fuel subsidies. The move, which raised gas prices by 44 percent, recalled austerity pledges that led to the collapse in 1998 of Suharto’s regime. With an economy still forecast to grow about 6 percent this year, reaction has been more muted. Yet wary investors have pushed the rupiah down near a four-year low.

Like Indonesia, Brazil is a major commodity exporter suffering from China’s slowdown. Both countries are raising interest rates to fight inflation, which could dampen growth even further. President Dilma Rousseff, after Brazil’s biggest street revolt in more than 20 years, has vowed to keep a lid on spending even as she addresses protesters’ demands for better schools, hospitals, and public transit.

“There’s a number of regimes that have built their legitimacy on fast growth,” says George Friedman, founder and chairman of policy-risk consultant Stratfor. Approval of Rousseff’s government dropped to 30 percent, from 57 percent, in June, putting at risk an expected reelection bid next year. “When people are disappointed, they go to the streets,” says Michael Shaoul, chairman and chief executive officer of Marketfield Asset Management. “They haven’t given that up just because they’ve had a good decade.”