Emerging Markets’ Nirvana Lost

SANTIAGO – In the 1970’s, the great Yale University economist Carlos Díaz-Alejandro used to say that the combination of high commodity prices, low world interest rates, and abundant international liquidity would amount to economic nirvana for developing countries. Back then, no sensible economist believed that such a state of grace could ever arrive. Yet arrive it did, and over the last decade commodity-rich countries like Brazil, Indonesia, Russia, and South Africa enjoyed its abundant benefits with abandon.

But now nirvana seems to be ending: commodity prices are down, and the mere possibility that the US Federal Reserve may end its policy of quantitative easing has raised market interest rates in the rich countries and sent funds fleeing from once-fashionable emerging markets back to safe havens in the North. Stock markets and currencies are plunging, and not just in commodity-rich emerging countries, but also in others, like India and Turkey, that had sucked in huge flows of foreign capital. Pessimists are already seeing a replay of the late-1990’s Asian crisis or, worse, an emerging-market echo of the 2008-2009 crisis in the advanced countries.

What the hardest-hit economies have in common are large external deficits. Abundant capital inflows caused their exchange rates to appreciate, making imports cheap and unleashing consumption (and sometimes investment) booms that eroded their trade balances, even as rising commodity prices boosted the value of their exports. Now the cycle is being reversed and exchange rates must depreciate to facilitate external adjustment. Anticipating that change – and the prospect of higher interest rates closer to home – foreign investors are taking flight, hastening and sharpening the exchange-rate plunge.

That is the bad news. The good news (fingers crossed) is that a full-fledged emerging-market financial crisis is unlikely. For one thing, this time was different with regard to fiscal behavior, as Luis Felipe Céspedes and I show in a recent paper.