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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.

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.