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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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