Wednesday, April 16, 2014
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Tailspin or Turbulence?

WASHINGTON, DC – Since the beginning of the year, a new wave of doubt has engulfed emerging markets, driving down their asset prices. The initial wave struck in the spring of 2013, following the Federal Reserve’s announcement that it would begin “tapering” its monthly purchases of long-term assets, better known as quantitative easing (QE). Now that the taper has arrived, the emerging-market bears are ascendant once again.

Pressure has been strongest on the so-called “Fragile Five”: Brazil, India, Indonesia, South Africa, and Turkey (not counting Argentina, where January’s mini-crisis started). But worries have extended to other emerging economies, too. Will the Fed’s gradual reduction of QE bring with it more emerging-market problems this year? To what extent are today’s conditions comparable to those that triggered the Asian crisis of 1997 or other abrupt capital-flow reversals in recent decades?

Emerging-market bulls point out that most major middle-income countries have substantially lowered their public debt/GDP ratios, giving them fiscal space that they lacked in the past. But neither the Mexican “Tequila crisis” of 1994 nor the Asian crisis of 1997 was caused by large public deficits. In both cases, the effort to defend a fixed exchange rate in the face of capital-flow reversals was a major factor, as was true in Turkey in the year prior to its currency collapse in February 2001.

Today, most emerging countries not only have low public-debt burdens, but also seem committed to flexible exchange rates, and appear to have well-capitalized banks, regulated to limit foreign-exchange exposure. Why, then, has there been so much vulnerability?

To be sure, the weakest-looking emerging countries have large current-account deficits and low net central-bank reserves after deducting short-term debt from gross reserves. But one could argue that if there is a capital-flow reversal, the exchange rate would depreciate, causing exports of goods and services to increase and imports to decline; the resulting current-account adjustment would quickly reduce the need for capital inflows. Given fiscal space and solid banks, a new equilibrium would quickly be established.

Unfortunately, the real vulnerability of some countries is rooted in private-sector balance sheets, with high leverage accumulating in both the household sector and among non-financial firms. Moreover, in many cases, the corporate sector, having grown accustomed to taking advantage of cheap funds from abroad to finance domestic activities, has significant foreign-currency exposure.

Where that is the case, steep currency depreciation would bring with it serious balance-sheet problems, which, if large enough, would undermine the banking sector, despite strong capital cushions. Banking-sector problems would, in turn, require state intervention, causing the public-debt burden to rise. In an extreme case, a “Spanish” scenario could unfold (though without the constraint of a fixed exchange rate, as in the eurozone).

It is this danger that sets a practical and political limit to flexible exchange rates. Some depreciation can be managed by most of the deficit countries; but a vicious circle could be triggered if the domestic currency loses too much value too quickly. Private-sector balance-sheet problems would weaken the financial sector, and the resulting pressure on public finances would compel austerity, thereby constraining consumer demand – and causing further damage to firms’ balance sheets.

To prevent such a crisis, therefore, the exchange rate has to be managed – and in a manner that depends on a country’s specific circumstances. Large net central-bank reserves can help ease the process. Otherwise, a significant rise in interest rates must be used to retain short-term capital and allow more gradual real-sector adjustment. Higher interest rates will of course lead to slower growth and lower employment, but such costs are likely to be smaller than those of a full-blown crisis.

The challenge is more difficult for countries with very large current-account deficits. And it becomes harder still if political turmoil or tension is thrown into the mix, as has been the case recently in a surprisingly large number of countries.

Nonetheless, despite serious dangers for a few countries, an overall emerging-market crisis is unlikely in 2014. Actual capital-flow reversals have been very limited, and no advanced country will raise interest rates sharply; in fact, with the United States’ current-account deficit diminishing, net flows from the US have increased over the last 12 months.

Moreover, most emerging-market countries have strong enough fiscal positions and can afford flexible enough exchange rates to manage a non-disruptive adjustment to moderately higher global interest rates. Much of the recent turmoil reflects the growing realization that financial-asset prices worldwide have been inflated by extraordinarily expansionary monetary policies. As a result, many financial assets have become vulnerable to even minor shifts in sentiment, and this will continue until real interest rates approach more “normal” long-run levels.

In the medium term, however, the potential for technological catch-up growth and secular convergence remains strong in most emerging countries. The pace of a country’s convergence will depend, even more than in the past, on the quality of governance and the pace of structural reforms.

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  1. CommentedCraig Stevenson


    I think you are wrong to state, simply, that assets will be imperiled when interest rates rise, I am not sure that is the case. But, am sure that assets have not merely risen to extraordinary heights during/after the GFC; rather, that this occurred during the previous period of expansion, and was likely exacerbated during the downturn from the story of delinked emerging markets and rising powers. It points to the quality of growth during the 2000's in which the global gdp doubled and the likely long-term flimsy nature of it. Such portends a multitude of things:

    one, that while the global system that was created in the aftermath of WWII was wildly successful if leaving much to be desired for meeting our universal and absolute ideals, much more need be done to advance the causes of global development

    two, the confused, listing, and aimless immediate post cold war era, that resulted in commitments to lessen poverty, need to evolve to something that ensures less free-riding among wealthy nations, rising powers, and developing countries alike. The disempowering dogma of critical post-colonialism, and neo-imperialism, scholarship, and their associated ideals and perspectives need to be addressed to place countries in the proper frame of the world we inhabit, not merely to run around in circles of what we would like it to be. So the confusion of the early post cold war era that led to the renewed drive for global development is to be continued, but excuses for free-ridership while observers mount their mighty steads of their unreal preferences need be subsumed to pragmatic responses relative to the intertwined world that we inhabit, which can advance standards of livings over time, but which can be interrupted if time-frames are unreal. If one were to plant hardwood forests for harvesting, one must realize that it takes a lifetime to build mighty oaks, not 15 years to solve poverty that has existed for millennia under conditions of much lessor population and greater material abundance.

    three, that the state led development model, which is trade diversionary, and reliant on the ballooning of balance sheets, can not be done more broadly in the world economy, and is likely needed to be addressed as discussions of governance advance, we should not sit idly by as some regions stress the boundaries of an open trading regime while others languish due to the manipulations of markets for internal development goals which are intertwined with global capital, trade and development structures more broadly than the parochial interests of some large powers, despite how humiliated they keep telling their people they should be.

    this is more broadly the case regionally, yet, the world is now more committed to development, and its participants more numerous. the rationale and desire for development is broadly felt, the excuse for subsumption of global development to the parochial internal needs derived of revisionist, even true, histories, can not delimit the trajectory of broader based development required for global stability in an era of super-empowered human's. Such, has been the case, to greater degrees since, the planting of crops and domestication of animals before the time of written history.

  2. CommentedMazhar Can

    A clear and enlightening piece by Dervis. However, there still remains 2 important caveats to make:

    1) Although an overall emerging-market crisis could be unlikely this year, it is conceivable to experience enduring strains here and there. This comes from the fact that FED tapering has the non-negligible possibility of inciting hitherto-absent volatility in EM assets, and this may easily lead to material sell-offs in EM markets with more depth (such as Poland, Turkey, South Africa and Hungary among others) due to market illiquidity elsewhere.

    2) It is also hard to argue that EM countries have delivered on structural reform front when the time was ripe. It remains to be seen whether recent Chinese blueprint will materialize in the end and it is well possible that there may be a reversal in consumption's weight in GDP or weakness in current account surplus this year. Also, Turkey - the most vulnerable country to capital outflows - squandered its chance to deliver supply-side reforms - in the aftermath of secular improvements brought by Dervis's IMF programme . All done was an exclusive demand management mainly by the central bank and the growth model was unfortunately disoriented by a government-led construction boom. So, the bottom line is that although a full-scale EM crisis is not likely as Dervis clearly points out, there are genuine candidates on the table who are about to feel the pinch (more).