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Save the Emerging Markets

CAMBRIDGE – If the world were fair, most emerging markets would be watching the financial crisis engulfing the world’s advanced economies from the sidelines – if not entirely unaffected, not overly concerned either. For once, what has set financial markets ablaze are not their excesses, but those of Wall Street. 

Emerging markets’ external and fiscal positions have been stronger than ever, thanks to the hard lessons learned from their own crisis-prone history. We might even have allowed these countries a certain measure of schadenfreude in the troubles of the United States and other rich countries, just as we might expect kids to take perverse delight from their parents’ getting into the kinds of trouble they so adamantly warn their children against.  

Instead, emerging markets are suffering financial convulsions of possibly historic proportions. The fear is no longer that they will be unable to insulate themselves. It is that their economies could be dragged into much deeper crises than those that will be experienced at the epicenter of the sub-prime debacle. 

Some of these countries should have known better and might have protected themselves sooner. There is little excuse for Iceland, which essentially turned itself into a highly leveraged hedge fund. Several other countries in Central and Eastern Europe, such as Hungary, Ukraine, and the Baltic states, were also living dangerously, with large current-account deficits and firms and households running up huge debts in foreign currency. Argentina, the international financial system’s enfant terrible , could always be relied on to produce a gimmick to spook investors – in this case a nationalization of its private pension funds. 

But financial markets have made little distinction between these countries and others like Mexico, Brazil, South Korea, or Indonesia, which until just a few weeks ago appeared to be models of financial health.

Consider what has happened to South Korea and Brazil. Both economies have experienced currency crises within recent memory – South Korea in 1997-1998 and Brazil in 1999 – and both subsequently took steps to increase their financial resilience. They reduced inflation, floated their currencies, ran external surpluses or small deficits, and, most importantly, accumulated mountains of foreign reserves (which now comfortably exceed their short-term external debts). Brazil’s financial good behavior was rewarded as recently as April of this year when Standard & Poor’s raised its credit rating to investment-grade. (South Korea has been investment-grade for years.)

But both are nonetheless getting hammered in financial markets. In the last two months, their currencies have lost around a quarter of their value against the US dollar. Their stock markets have declined by even more (40% in Brazil and one-third in South Korea). None of this can be explained by economic fundamentals. Both countries have experienced strong growth recently. Brazil is a commodity exporter, while South Korea is not. South Korea is hugely dependent on exports to advanced countries, Brazil much less so. 

They and other emerging-market countries are victims of a rational flight to safety, exacerbated by an irrational panic. The public guarantees that rich countries’ governments have extended to their financial sectors have exposed more clearly the critical line of demarcation between “safe” and “risky” assets, with emerging markets clearly in the latter category. Economic fundamentals have fallen by the wayside. 

To make matters even worse, emerging markets are deprived of the one tool that the advanced countries have employed in order to stem their own financial panics: domestic fiscal resources or domestic liquidity. Emerging markets need foreign currency and, therefore, external support.

What needs to be done is clear. The International Monetary Fund and the G7 countries’ central banks must act as global lenders of last resort and provide ample liquidity – quickly and with few strings attached – to support emerging markets’ currencies. The scale of the lending that is required will likely run into hundreds of billions of US dollars, and exceed anything that the IMF has done to date. But there is no shortage of resources. If necessary, the IMF can issue special drawing rights (SDRs) to generate the global liquidity needed.

Moreover, China, which holds nearly $2 trillion in foreign reserves, must be part of this rescue mission. The Chinese economy’s dynamism is highly dependent on exports, which would suffer greatly from a collapse of emerging markets. In fact, China, with its need for high growth to pay for social peace, may be the country most at risk from a severe global downturn.

Naked self-interest should persuade the advanced countries as well. Collapsing emerging-market currencies, and the resulting trade pressures, will make it all the more difficult for them to prevent their unemployment levels from rising significantly. In the absence of a backstop for emerging-country finances, the doomsday scenario of a protectionist vicious cycle reminiscent of the 1930’s could no longer be ruled out.

The United States Federal Reserve and the International Monetary Fund have both taken some positive steps.  The Fed has created a swap facility for four countries (South Korea, Brazil, Mexico and Singapore) of $30 billion each.  The IMF has announced a new quick-dispersing short-term facility for a limited number of countries with good policies.  The questions are whether these will be enough and what happens to those countries that will not be able to avail themselves of these programs.

So when the G-20 countries meet in Washington on November 15 for their crisis summit, this is the agenda item that should dominate their discussion. There will be plenty of time to debate a new Bretton Woods and the construction of a global regulatory apparatus. The priority for now is to save the emerging markets from the consequences of Wall Street’s financial follies.