The Missing Crisis

For several years now, capital has continued to flow from emerging markets. It has been driven by the prospect of higher interest rates in the U.S., falling commodity prices and slowing growth. Strangely enough, all of this hasn’t resulted in any large emerging country going bust.

Usually it is not worth noting when there is a lack of crisis. However, in this case it is since it demonstrates the extent to which the emerging world has become aware of what inherent dangers there are with fixed exchange rates, and unfortunately, how much is needed to be learned still.

For quite some time now, emerging markets have received major investments from foreign investors looking to capitalize on their promising economic potential. However, these kinds of investment inflows can be very fickle, and frequently will either completely reverse or slow down abruptly.

The International Monetary Fund, it its recent World Economic Outlook (which is semi-annual), made note of slowing capital inflows that occurred from 1981 through 1985. This coincided with the debt crisis for developing countries during the 1980s. There was another period from 1995 through 2000, which overlapped with the 1997-1998 Asian crisis.

According to the IMF, the current capital outflow episode started around 2010 and in terms of both size and breadth has been compared to similar episodes through the 1980’s and 1990’s. However, within the current episode there has been a much lower occurrence of external debt crises. In fact, the only emerging economy needing a bailout has been Ukraine. And keep in mind that Russia invaded that country, which is definitely an extenuating circumstance.

Emerging countries in the past fixed their exchange rates according to the dollar to provide certainty to investors and companies as well as to control inflation. At home, interest rates tended to a lot higher than rates in the U.S. Therefore, governments and domestic companies were able to borrow less expensively in dollars as long as this currency peg held.

Meanwhile foreign investors would lend in whatever the local currency was, and earn higher returns than would be possible with the dollar, as long as this same currency peg held. Therefore, quite perversely the belief in this currency peg encourages such a large amount of foreign currency debt to accumulate that the peg became even more vulnerable. With investors sensing the overvaluation of the currency (which is a normal consequence of inflation), they began to stop lending. As foreign capital began to be withdrawn, so much selling pressure was placed on the currency that is ended up collapsing. When foreign currency loans could not be repaid, governments, banks or companies went bust.

Over the past decade, orthodox macroeconomic policies were adopted by emerging markets. Their central banks were told to focus on inflation only and the lending institutions were staffed with apolitical technocrats who held PhDs from U.S. universities. Their exchange rates were also floated.

There were less predictable costs for foreign currency borrowing due to floating currencies. Therefore less of it was done by countries. According to the IMF, approximately 75% of debt from emergency market government is denominated now in local currency. By contrast in 1995 none of it was. In addition around 70% of corporate debt from emergency markets is in local debt, whereas in 1995 it was zero.

The IMF notes that it appears that flexible exchange rates have assisted some emerging markets with being able to mitigate the effects of capital flows slowing down through dampening global factor effects.

A more gradual adjustment for capital outflows has been produced by floating exchange rates. This has help to spare emerging markets of sudden stops that earlier eras experienced. In Europe, by contrast, the euro behave like a fixed currency that was on steroids. It funneled northern capital into southern economies. When this capital started to flee, the greatest of all sudden stops was experienced by the eurozone. Greece was the country that default, which is a developed country instead of a poor one. The banks that nearly failed were in Britain and the U.S. As Guillermo Ortiz quipped, who heads the central bank in Mexico, it wasn’t us this time.

In recent years the encouraging lesson has been that the severity and frequency of financial crisis can be significantly reduced by good macroeconomic policy. The bad new is this isn’t sufficient.

According to the IMF, since 2010, emerging market growth isn’t all that different from what it was from 1995 through 2000, even though the incidence of crises is much reduced.

Last year Brazil’s economy saw a contraction of 3.8%, and this year may shrink by almost that much. This would be the worst performance than any of the other crises it has experience over the past 36 years. There are multi-faceted reasons for this, ranging from high interest rates that has been designed to reduce inflation to declining commodity prices. Structural problems of state-directed corruption and bank lending, inadequate investment and excessive regulation lie underneath this poor cyclical performance. These are all problems that a majority of emerging markets are afflicted with to varying degrees.

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