Emerging Markets’ Bubble Troubles

ROME – Some of the developing world’s larger countries, flush with capital after being recognized by investors as “emerging-market economies” (EMEs), have been pursuing policies with little regard for the lessons of the financial crises of 1997-1998 and 2008-2009. As a result, countries like India, Brazil, South Africa, and Indonesia have been hit by the US Federal Reserve’s gradual exit from so-called quantitative easing (QE) – not just capital-flow reversals, but also a sharp decline in domestic asset prices.

Various developments last year raised expectations that the Fed would begin to taper its $85 billion-per-month open-ended bond-buying program sooner rather than later. This drove up US government-bond yields, and reduced the appeal of higher-yielding EME currencies. As a result, several EME currencies, from the Indian rupee to the Turkish lira, declined sharply.

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Moreover, some EMEs have experienced financial-market disruptions and slowing economic growth. Such developments often lead to perverse economic behavior, as rumors and pessimistic predictions become self-fulfilling.

Typically, after international investors “discover” an EME, it receives massive – but easily reversible – capital inflows. The influx of cash fuels domestic asset-price bubbles and booms in related sectors of the real economy, pushing up the real exchange rate and, in turn, weakening incentives for domestic producers.

This drives investors to put even more of their money in non-tradable sectors, such as construction and real estate. The growing current-account deficit is largely ignored, as long as capital inflows continue to cover it and economic growth remains strong. Short-lived market rallies make matters worse, frequently inducing further unfounded exuberance. And when officials recognize the problem, hurriedly announced policy measures, such as capital controls, are usually too little too late, and can have adverse effects in the short term.

Investors, long encouraged to take a short-term view, may be surprised by such developments. But there is little excuse for the failure of policymakers and researchers to anticipate the recent capital-flow reversal. After all, while the Fed’s tapering of QE undoubtedly has contributed to recent events, many EMEs have been in trouble for quite a while, with output growth decelerating gradually and private investment declining.

Capital-fueled economic booms do not significantly improve most people’s lives, because public expenditure on infrastructure, health care, sanitation, education, and social protection does not rise adequately to compensate for adverse consequences. These consequences include accelerating consumer-price inflation (despite slowing GDP growth) and worsening external balances as currency appreciation weakens export growth and feeds a growing appetite for imports.

Many recent EME booms have involved debt-financed consumption binges and investment sprees that relied largely on short-term capital inflows. Making matters worse, the euphoria accompanying bubbles in stock and property markets has fueled credit expansion for businesses and households, with rising private and, in some cases, public debt, as well as current-account deficits, increasingly financed by “hot money” from abroad.

Such debt-driven bubbles have long been known to be unsustainable. But those who have warned of the EMEs’ impending busts have been dismissed as “prophets of doom” who underestimate the EMEs’ potential. The marginalization of economic history in economics education is now exacting a high toll.

The facts are simple: bubbles can collapse easily and quickly, and controlling a panic is virtually impossible. Once markets turn, many of the policies – and policymakers – celebrated during the boom are recast as in a far dimmer light. Former US Federal Reserve Chairman Ben Bernanke may be blamed this time, but EME busts can easily be triggered by anything from a minor change in global conditions to an unexpected growth hiccup or domestic political instability. Even economic difficulties in a neighboring country could be sufficient to prick a bubble.

The resulting crisis, by reducing employment and incomes, stands to hurt many innocent bystanders, most of whom did not benefit significantly from the boom. This is already happening in several EMEs, just as it has occurred many times elsewhere. How many more such episodes must the world endure before they are recognized as the avoidable disasters that they are?

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