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?