LONDON – Over the last decade, America’s expansionary monetary policy and China’s rapid growth have been the two key drivers of global financial flows. Now, both dynamics are being reversed, generating new risks for the global economy – particularly for emerging countries. Whether they can cope with these changes will depend on whether they have taken out enough insurance against the right risks.
Following the Asian financial crisis of the late 1990’s, emerging economies began to accumulate massive foreign-exchange reserves to protect themselves against the risks of external over-indebtedness. In fact, they amassed far more than they needed – $6.5 trillion, at last count – effectively becoming over-insured against external balance-of-payments shocks.
But they remained underinsured against domestic credit risks – the leading threat to emerging economies today. After the global financial crisis erupted in 2008, interest rates plummeted, fueling private-sector credit booms in many of the largest emerging markets, including Brazil, India, Indonesia, and Turkey.
Although these booms were initially financed by domestic capital, they soon became dependent on foreign capital, which flowed into their economies as advanced-country central banks pumped huge amounts of liquidity into financial markets. Now, just as the US Federal Reserve contemplates an exit from its unconventional monetary policies, emerging economies’ current-account positions are weakening, making their reliance on capital inflows increasingly apparent – and increasingly dangerous.