Emerging Markets’ Nirvana Lost

Andrés Velasco

11 September 2013
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SANTIAGOIn 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 homeforeign 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.
 
Commodity-rich governments did not spend the entire windfall and more, as they had done during earlier commodity booms. So government debt and the resulting financial vulnerability are not as high as they were in the past.
 
These countries’ private sectors have borrowed significantly; but, as the Nobel laureate economist Paul Krugman has been pointing out, leverage and dollar debt are lower (as a share of national income) than they were at the outset of the 1990’s Asian crisis – and at the start of the 1980’s Latin American crisis, for that matter.
 
So, in my view, the question is not whether these countries’ financial sectors will explode, but whether their growth trajectories will implode.
 
When commodity prices are sky-high and money is cheap and plentiful, economic growth is almost inevitable. In Latin America over the last decade, countries with sound macroeconomic policy frameworks, like Colombia, Peru, and Chile, grew rapidly. But so did Argentina, a country whose government seems to start every day wondering what more it can do to weaken economic institutions and damage long-term growth prospects.
 
Now that nirvana is over, where will growth come from? To answer that question, it helps to note, as Harvard University’s Ricardo Hausmann has done recently, that some of the emerging economies’ recent growth was illusory. Wall Street became enamored with the rapidly rising dollar value of these countries’ national income, but that rise had more to do with strong commodity prices and appreciating exchange rates (which raised the value of their output when measured in dollars) than with sharp increases in actual output volumes.
 
During the boom years, structural transformation in many emerging economies, particularly in Latin America, was limited. Countries like Ireland, Finland, and Singapore – and also South Korea, Malaysia, and Indonesiaexport different goods (and to different markets) than they did a generation ago. By contrast, Chile’s export basket is pretty much the same as it was in 1980.
 
There is nothing wrong with exporting copper, wine, fruit, and forest products. But economic history suggests that countries seldomif ever get rich by doing just that. Commodity-rich advanced economies like Canada, Norway, or Australia export lots of natural resources, of course, but they also export many other goods and services. That is not true of Chile, Peru, or Colombia – or even of Brazil, with its much larger population and more developed industrial base.
 
To make matters worse, unlike their Asian counterparts, Latin America’s economies are not integrated into regional and global value chains. A producer in Indonesia, Malaysia, or the Philippines can easily take advantage of the local currency’s depreciation to sell more electronic components to an assembly plant in China with which it has a long-standing and well-developed supply relationship. A business in Concepción, Arequipa, or Medellín, by contrast, must seek new customers in new countries, which takes time and money – and may not succeed.
 
Latin American governments could have used the opportunities afforded by the global commodity and liquidity booms to diversify their economies, working with local business communities to move into new products and sectors. They did not.
 
In some of these countries, conservative governments viewed industrial promotion as some dirigiste relic from the past, and avoided it. In othersBrazil comes to mindleft-leaning governments practiced industrial promotion in such a heavy-handed and erratic way that they ended up weakening whatever it was they wanted to promote. The time has come to pay for these mistakes.
 
Nirvana” is defined as the state of freedom from suffering. For emerging markets, that state is over; but, in some cases, their citizensstill feeling rich from cheap money and high export priceshave no inkling of the suffering that may be upon them. For the sake of political stability, governments would be well advised to inform them.
 
 
Andrés Velasco, a former presidential candidate and finance minister of Chile, is Professor of Professional Practice in International Development at Columbia University's School of International and Public Affairs. He has taught at Harvard University and New York University, and is the author of numerous studies on international economics and development.


Last updated: September 12, 2013 6:32 pm

 
The audacity of stealth – Merkel’s plan for the euro
 
The German chancellor grasps that there is more to leadership than rhetoric
 
Angela Merkel
 
 
So might miserly Merkel play the last act as audacious Angela? The rest of Europe dearly hopes so. I cannot recall the last time a German election had the rest of us on the edge of our seats. But then this month’s poll is as much about the future of Europe as it is about the condition of Germany.
 
The suspense does not hang on polling day. The universal assumption – I suppose it could be wrong? – is that whatever the precise disposition of political forces when the votes are counted on September 22, Ms Merkel will secure a third term as chancellor. And would a grand coalition of her Christian Democrats with the opposition Social Democrats veer off in a direction markedly different from that of the present pact with Free Democrats? Probably not.
 
By all accounts, Ms Merkel has decided that a third term would be her last. She wants to avoid the mistake of her mentor Helmut Kohlstaying too long. Some think she could depart before the end of the term. We Brits remember how Margaret Thatcher was slightly mad by the time she went. Whether circumstance allows Ms Merkel to bow out early is another question.
 
The resolutely parochial nature of the election campaign has fitted Germany’s mood. Save for selling lots of things to China, the country feels much better looking inward than outward. The euro crisis that has so long dominated European politics has flared only briefly on the campaign trail. The eurosceptic Alternative for Germany party, or AfD, could spring a surprise by crossing the 5 per cent threshold for seats in the Bundestag. Most polls suggest not. In any event, a full two-thirds of Germans have concluded they are safe with Ms Merkel.
 
For all that, the fate of the euro and the EU will draw the contours of a third term – and settle the chancellor’s place in history. The immediate threat to the single currency has passed. But decisions takenmostly, though not entirely, by Germanyduring the coming few years will determine whether the euro can be put on a sound footing. History may yet record Ms Merkel as the leader who presided over the collapse of a unique experiment in European integration; or as the German chancellor who steered a badly-leaking ship into safe harbour.

I struggle to make up my mind about Ms Merkel. Like many, I have been sharply critical of her one-minute-to-midnight approach to decision making during the euro crisis which, apart from raising the blood pressure of leaders as distant as Washington and Beijing, has increased the cost of stabilising the single currency. Yet there is also a nagging admiration. Unflappability is a rare commodity in modern politics. So is careful deliberation.
 
The case for the prosecution is easily made, even if one discounts the more hysterical charges laid against the chancellor in some of the eurozone’s southern states. Germany’s economic power carries responsibilitieswithin and beyond Europe. Forcing unparalleled austerity on her partners at the price of depression and record unemployment is not the way to build a cohesive EU. The burden of economic adjustment must fall on creditors as well as debtors. Leadership requires a willingness to mould public opinion rather than be caught in its thrall.

Expecting US President Barack Obama to make hard choices to uphold order in the Middle East while allowing Germany to disavow any complicity is not a foreign policy fit for Europe’s pre-eminent power. Protecting feckless German banks while punishing debtors in Spain, Portugal or Ireland scarcely speaks to solidarity. The chancellor’s critics can produce a long list.

There is, however, another possible narrative. This says that Ms Merkel understands there is more to leadership than vaulting rhetoric (look at how much trouble Mr Obama has got himself into). Effectiveness is about marrying the desirable with the possibleexpanding the boundaries, yes, but also carrying popular support. Ms Merkel, in this guise, knows Germany is best led from behind.

The reality is that Germany has moved since the crisis erupted. Three or four years ago it was impossible to imagine that it would support a €500bn bailout fund in the form of the European Stability Mechanism; that it would sign up to two rescue deals for Greece and be ready, once the polls have closed, to contemplate a third; and that the chancellor would defy the sacred Bundesbank to support an open-ended commitment to the debtors from the European Central Bank. The future of the euro rests with German consent. The voters have been led – but almost without realising it.
 
There is one more thing. Ms Merkel’s judgment that the euro can flourish in the long term only if weaker economies undertake the reforms needed to restore national competitiveness is essentially right. Solidity in return for solidarity is not a bad slogan.

For the future, two things are clear. The first is that the eurozone nations are not going to build the federal Europe deemed vital by those with overly tidy minds. The pace of integration should quicken, particularly in areas such as banking union, but Europe’s single currency will remain, like the EU itself, a hybrid – a monetary union with both collective rules and national decision making. The second is that getting there will not be a smooth process. There are plenty of squalls ahead.

Ms Merkel’s settled view is that Germany’s prosperity and security rest on sustaining the euro. There will be no grand gestures, but she will do what is necessary. Forget eurobonds but think of German acquiescence in loose monetary policy. Watch Berlin ease up on the deficits of those states that prove themselves serious about structural reform. Is there such a thing, I sometimes wonder, as stealthy, even miserly, audacity?

 
Copyright The Financial Times Limited 2013.


OPINION


September 10, 2013, 6:53 p.m. ET

Alan Blinder: Five Years Later, Financial Lessons Not Learned

A good-though-weak law sinks under the weight of special-interest lobbies.

By ALAN S. BLINDER

 

Next Sunday marks the fifth anniversary of the fateful day that investment bank Lehman Brothers filed for bankruptcy, signaling the start of a frightening financial meltdown. It's a good time to ponder how the U.S. economy was nearly brought to ruin. But will we? Or are we already forgetting?
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Consider the stark historical contrast between the 1930s and this decade: 

Years of financial shenanigans in the 1920s, some illegal but many just immoral, conspired with a variety of other villains to bring on the Great Depression. Congress and President Roosevelt reacted strongly, virtually remaking the dysfunctional U.S. financial system, including establishing the Securities and Exchange Commission to protect investors, the Federal Deposit Insurance Corp. to protect bank depositors, and much else. The financial beast was comparatively tamed for almost 75 years. 

Years of disgraceful financial shenanigans in the 2000s, some illegal but many just immoral, brought on the Great Recession with virtually no help from any co-conspirators. Congress and President Obama reacted comparatively weakly with the Dodd-Frank Act of 2010, which certainly did not seek to remake the U.S. financial system. I am a big supporter of Dodd-Frank, despite its timidity, because laws must be graded on a curve. Sadly, even this good-though-weak law now seems to be withering on the regulatory vine. Far from being tamed, the financial beast has gotten its mojo back—and is winning. The people have forgotten—and are losing.
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Here are four examples. There are others.
 
 AFP/Getty Images
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On Sept. 29, 2008, the Dow Jones Industrial Average sank 777.68 points..

 Mortgages and securitization. Piles of unconscionably bad mortgagesunderwritten by irresponsible bankers, permitted by somnolent regulators, and passed on like hot potatoes to investors via securitization—were a major contributor to the financial crisis. One response in Dodd-Frank was a "risk retention" rule requiring issuers of asset-backed securities to retain at least 5% of the credit risk, rather than pass it all on to investors. The idea was that a little "skin in the game" would make Wall Street firms a bit more cautious about what they securitized.  

But there was a catch. The 5% requirement does not apply to "qualified residential mortgages" (QRMs)—a term left to regulators to define, but intended to exempt safe, plain-vanilla mortgages with negligible default risk. Dodd-Frank does not ban mortgages that do not qualify as QRMs, nor even does it prevent such mortgages from being securitized. It only requires that lenders retain a tiny portion of the credit risk.  

The law mandated that a specific rule be written within 270 days. More than 1,100 days have now passed, and the country is still waiting. Just days ago, the regulators issued yet another notice of proposed rulemaking, soliciting comments on (among many other things) two ways to define QRMs.  The lighter-touch option would exempt almost 95% of all mortgages from the skin-in-the-game requirement. The "tougher" option would exempt almost 75%. Does anyone doubt which option will be favored by interested commentators? After that, what will be left of the Dodd-Frank requirement? 

Derivatives. Disgracefully bad mortgages created a problema. But wild and woolly customized derivativestotally unregulated due to the odious Commodity Futures Modernization Act of 2000blew the problem up into a catastrophe. Derivatives based on mortgages were a principal source of the reckless leverage that backfired so badly during the crisis, imposing huge losses on investors and many financial firms. Dodd-Frank calls for greater standardization and more exchange-trading, which would create a safer and more transparent trading environment. Wonderful ideas. But the law exempts the vast majority of derivatives. Do you see a pattern here? 

It gets worse. Gary Gensler, the chairman of the Commodity Futures Trading Commission, is one of the few real reformers. But he ran into a wall of resistance from the industry, from European regulators, and from some of his American colleagues when he tried to implement even the weak Dodd-Frank provisions for derivatives. And Mr. Gensler's days leading the CFTC look numbered.  

Rating agencies. The credit-rating agencies also contributed mightily to the financial mess. These private, for-profit companies were presumed responsible for calling out hazards. Instead, they blessed financial junk with coveted triple-A ratings. Honest mistakes? Perhaps. But many critics have pointed out a flaw that cries out for fixing: The agencies are hired and paid by the very companies whose securities they rate. 

Unfortunately, Congress could not decide how to fix this flaw. So Dodd-Frank instructed the Government Accountability Office to study "providing incentives to credit rating agencies to improve the credit rating process" and report back within 18 months. The law also instructed the Securities and Exchange Commission to study "strengthening credit rating agency independence" and report back within three years. The GAO issued a report 18 months later, laying out a number of options; it has gathered dust ever since. And the SEC? Well, don't get me started. Amazingly, the rating agencies are still compensated as they were on the day Lehman Brothers crashed. 

Proprietary trading. The Volcker rule, part of Dodd-Frank, bans proprietary trading by banks, to prevent them from gambling with FDIC-insured funds. President Obama embraced (and named) the rule very late in the legislative game, over the objections, according to multiple press reports, of his chief economic adviser at the time, Lawrence Summers

The Volcker rule is not the only way to accomplish Paul Volcker's worthy objective. The United Kingdom and the European Union, for example, have proposed different means to the same end. But the Volcker rule is the law of the land here.

Sort of. In practice, the rule is hortatory until detailed regulations are written and promulgated. Dodd-Frank was signed into law in July 2010. The Volcker rule has been tied up ever since by internal bureaucratic squabbles and external pressure from the banking industry.

In sum, the Dodd-Frank Act is taking on water fast. What can be done to help Americans remember the horrors that led to its passage?  

Here's one step. Mr. Obama will soon nominate a new chair of the Federal Reserve Board. The Fed chief is not a regulatory czar, but she or he is primus inter pares among the nation's financial regulators. The Fed's next chair can set a new, more determined tone going forward—or not. So it is vital that she or he be prepared to move bureaucratic mountains and fend off hordes of lobbyists opposing financial reform, not to bleed sympathy for Wall Street. 

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of "After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead" (Penguin, 2013).
 

Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved


Inside Business

September 12, 2013 2:20 pm

The shaking up of Europe’s old order

Financial disentanglement in Italy and Spain depends on how well the order is broken down
 
 
Like the walls of biblical Jericho, the fortifications of modern Mediterranean capitalism were once all but impregnable. Now the shrill blast of trumpets is sounding below the ramparts.

Under pressure from within and without, the hierarchs of Spanish and Italian finance are set to dismantle industrial cross-shareholdings, which they have guarded for up to six decades like towers full of treasure.
 
Disentangled from each other, banks, insurers and non-financial companies will surely have healthier, rules-based relationships with investors, politicians and regulators. But much depends on how comprehensively the old order is broken down. Neither in Italy nor in Spain is the outlook entirely clear.

In post-1945 Italy, Enrico Cuccia, a hermit emperor of finance, amassed extensive industrial holdings for what at first was the unimpeachable cause of national economic recovery. His vehicle was Mediobanca, the Milan investment bank.
 
Much the same story played out in post-Franco Spain, when bankers took stakes in privatised groups such as Repsol, the oil and gas company, and Telefónica, the telecoms operator. But what the financiers also did, not by accident, was to minimise foreign influence over big business and, with a nod and a wink from the state, to weld politically connected banks, industrial groups and family-owned fortunes into phalanxes of national power.

On a tide of five years of unremitting economic crisis, change is at last coming to southern Europe. Business leaders and European regulators are stirring into action. At Mediobanca and Generali, the Trieste-based insurer, executives promise to sell once precious stakes in airports, hotels, media and telecoms. Money and expertise are to be channelled into the core activities of retail banking, investment banking and insurance.
 
In short, Generali and Mediobanca are losing their appetite to continue as the half-hidden ringmasters of Italian big business. Both are considering selling their lossmaking interests in Telco, the holding company that has a 22.4 per cent stake in Telecom Italia, after restrictions on sales are lifted on September 28.
 
Boldness seems to have limits, however. Mediobanca is not committing itself to sell its entire 13 per cent holding in Generali. Nor is it certain that UniCredit, Italy’s biggest lender by assets, the Benetton family or Silvio Berlusconi’s Fininvest group will sell their stakes in Mediobanca. Still, the old plutocratic shareholder pacts, cascades of holding companies, favours for insiders and inefficient allocation of resources are under threat. They might have passed muster in the 1960s when companies such as Fiat, an icon of postwar industrial success, flourished under Mediobanca’s aegis. But 50 years on, they will contribute no more to solving Italy’s problems than would a bill of exchange signed by Cosimo de’ Medici.
 
In Spain, no bank is more central to the network of cross-shareholdings than Caixabank of Barcelona, with its stakes in companies such as Repsol, Telefónica, Gas Natural, the utility, and Abertis, the infrastructure group. But Caixabank seems in no hurry to sell. Instead, the trailblazer is Bankia, a nationalised lender created in 2010 from seven cajas, or regional savings banks. European regulators demanded disposals as a condition of Bankia’s €24bn bailout a year ago. They set similar terms for Galicia-based NCG Banco, Catalunya Banc and Banco de Valencia. In other words, the pressure to shake up old ownership structures in Spain is largely external rather than, as in Italy, largely internal – though in both cases financial urgency is the main force behind change.
 
Bankia’s asset sales are already reshaping Spain’s industrial landscape. In June, the bank sold a 12 per cent stake in International Airlines Group, the company born out of a 2011 merger between British Airways and Iberia, the Spanish carrier. The €675m deal removed all direct Spanish influence over Iberia, once an emblem of the nation’s identity and global presence.
 
In principle the reform of Italian and Spanish capitalism will reduce political interference in banks, foster more efficient use of capital and strengthen protections for minority shareholders. By and large, this was the happy outcome in Germany when Allianz, Deutsche Bank, Dresdner Bank and Munich Re sold their industrial stakes from the late 1990s on. It was not a painless process: Dresdner became an ever weaker bank and bankruptcy engulfed companies such as Karstadt, the retailer, which had once been protected by bank shareholders. But it would be a pity if fear of similar upheavals were to block long overdue reforms of business structures and practices in Italy and Spain.

Tony Barber is the Financial Times’ Europe editor

 
Copyright The Financial Times Limited 2013.