Emerging markets

Don’t panic

There is no reason for a broad emerging-market crisis. But nervous investors could yet cause one

Feb 1st 2014

A CENTRAL bank doubles interest rates after an emergency meeting at midnight. A country is forced into a big devaluation as foreign-exchange reserves dwindle. Recent events in Turkey and Argentina have eerie echoes of the early stages of the 1997-98 emerging-market crisis. That disaster started with isolated problems in Thailand. But it morphed into a general crash, as investors fled all emerging-market assets, currencies collapsed, economies slumped and foreign debts proved unpayable. Could 2014 bring a repeat?

Optimists, whose ranks include the International Monetary Fund, say no. They argue that most emerging markets are far less vulnerable than they were in 1997. They have flexible exchange rates; their reserves are higher (a whopping $7.7 trillion in total); their current-account deficits are smaller (only two of the 25 emerging markets tracked by The Economist have a deficit above 5% of GDP); their debts are lower and more likely to be denominated in domestic currency.

Pessimists, many of them on hedge-fund trading desks, put more weight on factors that make emerging-market assets less attractive, particularly the prospect of higher interest rates in America and slower growth in China. After years of chasing yield in risky places, many American investors are bringing their money home (see article). And after years of booming credit growth, emerging economies have new vulnerabilities: complacent politicians, high corporate-debt loads and banks that are dodgier than they appear.

On balance, this newspaper sides with the optimists. The days of easy money are ending, but slowly. Most emerging markets are less vulnerable than they were 15 years ago, and are building up their defences fast. The wild card is panic. Even if the economic fundamentals do not warrant large-scale flight by investors, currency crises can become self-fulfilling, particularly in relatively illiquid markets.

Most emerging-market currencies have slid in the past week, but the real pressure has been on a few countries with glaring weaknesses, such as Argentina (high inflation, erratic government) and Turkey (high inflation, gaping deficit, political upheaval). The differentiation is encouraging. So, too, has been emerging economies’ response. By and large policymakers have used market turmoil to push through more reform

Central banks that took their eye off inflation are toughening up. On January 28th India’s central bank raised rates for the third time in five months, and made clear it was moving towards an inflation target. Turkey’s central bank scrapped its daft monetary policy for a more orthodox one, and jacked up interest rates. There is more to do: in too many emerging markets real interest rates are still negative. But the direction is the right one, and most countries are moving fast.

Yet these countries are not wholly in control of their currencies’ fates, for the flow of capital into and out of emerging markets has far more to do with what happens beyond their borders than with what they do at home. When the Federal Reserve raises rates in America, emerging economies often hit trouble, particularly if the rate increases are rapid

Fortunately, that is unlikely today. The Fed is slowly cutting back the monetary morphine—at its meeting on January 29th it cut its monthly bond-buying by another $10 billion—but the odds of precipitous tightening are small. The Fed’s new chairman, Janet Yellen, has made clear that it will keep its policy rate near zero until America’s labour market recovers. And that means more than just a lower jobless rate.

Bears in a China shop

Equally, the chances that trouble in China will fell other emerging economies are low. Sharply slower Chinese growth would hit commodity exporters elsewhere, but there is no sign of such a sudden slump. It is true that China’s financial system faces mounting difficulties, but the government has the capacity to bail it out

The country’s huge stash of savings means that internal bank failures do not have a direct economic link to the rest of the emerging world. It is only nervy investors who see a connection between a failed Chinese shadow bank and tumbling currencies elsewhere.

If enough investors get nervous, money will flood out, currencies will fall and a gradual tightening could become a sudden rout. But there is no reason for American interest rates to rise fast, and no reason why emerging economies cannot adapt to a world in which rates gradually climb.

Emerging markets

Locus of extremity

Developing economies struggle to cope with a new world

Feb 1st 2014

THE central bank of Turkey boasts an impressive art collection, including a canvas by Erol Akyavas entitled “Locus of Extremity”. That was pretty much where the central bank found itself at midnight on January 28th. Turkey’s currency, the lira, had fallen by 13% against the dollar in the previous six weeks, one of the worst casualties of a broader sell-off in emerging-market assets. Prices were rising (by 7.4% in the year to December) and yet the political pressure to suppress interest rates remained firm. At its unscheduled, nocturnal meeting, the central bank dramatically simplified and tightened monetary policy, raising what will henceforth be its key rate from 4.5% to 10%.

The Turks were not alone. Earlier that day India’s central bank also surprised people by raising rates (albeit by a less extreme 0.25 percentage points) for the third time in five months. South Africa’s monetary authorities followed suit the next afternoon, lifting rates by 0.5 points. The trio deemed their tightening necessary to keep a lid on troublesome inflation and to give a lift to their battered currencies. But it gave their exchange rates only a fleeting lift; late on January 29th they were wobbly again.

These three economies, alongside Brazil and Indonesia, belong to the “fragile five”. Their currencies suffered dramatic declines last year, after Ben Bernanke, the chairman of America’s Federal Reserve, was tactless enough to say that it would not keep printing money to buy bonds at the same pace for ever. The beleaguered five enjoyed some respite in September, when the Fed decided to maintain its “quantitative easing” for a few months more. But in the past two weeks foreign investors have once again found reasons to sell (see chart 1).

They did not have to look too hard. In recent months Argentina has squandered a big chunk of its foreign-exchange reserves in a doomed defence of the peso, which eventually fell by about 20%, despite the government’s fitful efforts to curtail capital outflows. On January 23rd a widely watched index of manufacturing in China fell by more than expected, raising the prospect of slowing growth amid excessive credit. In Turkey, the sons of three cabinet ministers were arrested in December in a corruption scandal. Meanwhile, in both icy Kiev and balmy Bangkok, protesters are on the streets.

These local difficulties, not all of them little, are unfolding against the backdrop of a gradual rise in global interest rates, as America’s economy strengthens and the Fed moderates its bond purchases. Yields on ten-year Treasuries are still low: about 2.8%. But that is more than one percentage point higher than nine months ago. At Mr Bernanke’s last meeting as chairman, on January 29th, the Fed decided to cut its monthly purchases by another $10 billion, having done the same in December.

The Fed’s bond-buying was not popular in emerging economies. Brazil’s finance minister, Guido Mantega, once accused the rich world of unleashing a currency war: the Fed’s easy money cheapened the dollar, reducing the demand for emerging-market goods. But now that quantitative easing is slowly ceasing, the developing world faces the opposite problem: the Fed’s cutbacks will cheapen American bonds, reducing the demand for emerging-market assets. Alexandre Tombini, governor of Brazil’s central bank, has likened rising rates in the rich world to a “vacuum cleaner” that will suck foreign money out of emerging economies.

How dependent on that money are emerging economies? The amount of emerging-market bonds and equities that foreigners have accumulated is impressive (see chart). But the income and wealth of the emerging economies have also grown over that period. The 30 most prominent such economies account for almost 40% of global GDP, notes the Institute for International Finance, which represents global banks. Yet their weight in benchmark portfolios of global stocks is only about 13%.

As a group, the emerging economies are actually net exporters of capital to the rest of the world. Even as they have attracted large private capital inflows, their central banks have engineered an even greater capital outflow by accumulating big foreign-exchange reserves. They smoked foreign capital but they did not inhale, as Martin Wolf of the Financial Times once put it.

That is true of the group as a whole. But it is not the case for every member, some of whom breathed deep. Turkey, South Africa, India, Brazil and, latterly, Indonesia have all run troublesome current-account deficits, which have left them vulnerable to capital outflows

Moreover, the current-account is “only the bit of the balance of payments that you can see above the surface,” notes Kit Juckes of Société Générale. Countries can experience large and potentially destabilising capital flows in both directions, even as their current account remains roughly in balance, if inflows differ greatly from outflows in their liquidity, maturity or currency.

India and Indonesia have tried to limit their exposure. India has narrowed its current-account deficit dramatically, helped by a ban on gold imports. Indonesia cut fuel subsidies in June and taxed luxuries that are largely imported. And both countries let their currencies fall—a symptom of overstretch that (by encouraging exports and deterring imports) is also a partial remedy.

Having endured big falls since May, the currencies of both India and Indonesia have stood up well to the recent turmoil. The currencies of South Africa and Turkey have not. Their rate hikes this week will help to restore the higher real yields their assets must pay to attract foreign investors.

But according to Mr Juckes, this absolute yield differential is not all that matters. Once rich-country pension funds are earning more than a derisory amount on staid investments at home, they will be far more reluctant to venture into anythingexcitingabroad, even if the spread between domestic and foreign rates remains the same in absolute terms. “Part of me wants to look at interest-rate ratios not interest-rate differentials,” he says. In other words, if American ten-year yields go up from 2% to 3%, it is not enough for emerging-market yields to go up by one percentage point. They have to go up by half.

As real long-term interest rates rise above zero in America, global investment managers are going through an enormousone-off adjustment”, Mr Juckes reckons. They are anticipating a “more normal world”, in which pension funds can meet their obligations by holding safe but rewarding assets in countries they know well. It was a world America began to leave behind in late 2007, when the crisis broke and the dramatic rate cuts started. At that time, curiously enough, the central bank of Turkey’sLocus of Extremity” was on loan to America’s Federal Reserve.

The Trouble with Emerging Markets

Nouriel Roubini

JAN 31, 2014
Newsart for The Trouble with Emerging Markets

LAGOSThe financial turmoil that hit emerging-market economies last spring, following the US Federal Reserve’s taper tantrum” over its quantitative-easing (QE) policy, has returned with a vengeance. This time, the trigger was a confluence of several events: a currency crisis in Argentina, where the authorities stopped intervening in the forex markets to prevent the loss of foreign reserves; weaker economic data from China; and persistent political uncertainty and unrest in Turkey, Ukraine, and Thailand.

This mini perfect storm in emerging markets was soon transmitted, via international investors’ risk aversion, to advanced economies’ stock markets. But the immediate trigger for these pressures should not be confused with their deeper causes: Many emerging markets are in real trouble.

The list includes India, Indonesia, Brazil, Turkey, and South Africadubbed the “Fragile Five,” because all have twin fiscal and current-account deficits, falling growth rates, above-target inflation, and political uncertainty from upcoming legislative and/or presidential elections this year. But five other significant countriesArgentina, Venezuela, Ukraine, Hungary, and Thailand – are also vulnerable. Political and/or electoral risk can be found in all of them, loose fiscal policy in many of them, and rising external imbalances and sovereign risk in some of them.

Then, there are the over-hyped BRICS countries, now falling back to reality. Three of them (Brazil, Russia, and South Africa) will grow more slowly than the United States this year, with real (inflation-adjusted) GDP rising at less than 2.5%, while the economies of the other two (China and India) are slowing sharply. Indeed, Brazil, India, and South Africa are members of the Fragile Five, and demographic decline in China and Russia will undermine both countries’ potential growth.

The largest of the BRICS, China, faces additional risk stemming from a credit-fueled investment boom, with excessive borrowing by local governments, state-owned enterprises, and real-estate firms severely weakening the asset portfolios of banks and shadow banks. Most credit bubbles this large have ended up causing a hard economic landing, and China’s economy is unlikely to escape unscathed, particularly as reforms to rebalance growth from high savings and fixed investment to private consumption are likely to be implemented too slowly, given the powerful interests aligned against them.

Moreover, the deep causes of last year’s turmoil in emerging markets have not disappeared. For starters, the risk of a hard landing in China poses a serious threat to emerging Asia, commodity exporters around the world, and even advanced economies.

At the same time, the Fed’s tapering of its long-term asset purchases has begun in earnest, with interest rates set to rise. As a result, the capital that flowed to emerging markets in the years of high liquidity and low yields in advanced economies is now fleeing many countries where easy money caused fiscal, monetary, and credit policies to become too lax.

Another deep cause of current volatility is that the commodity super-cycle is over. This is not just because China is slowing; years of high prices have led to investment in new capacity and an increase in the supply of many commodities. Meanwhile, emerging-market commodity exporters failed to take advantage of the windfall and implement market-oriented structural reforms in the last decade; on the contrary, many of them embraced state capitalism, giving too large a role to state-owned enterprises and banks.

These risks will not wane anytime soon. Chinese growth is unlikely to accelerate and lift commodity prices; the Fed has increased the pace of its QE tapering; structural reforms are not likely until after elections; and incumbent governments have been similarly wary of the growth-depressing effects of tightening fiscal, monetary, and credit policies. Indeed, the failure of many emerging-market governments to tighten macroeconomic policy sufficiently has led to another round of currency depreciation, which risks feeding into higher inflation and jeopardizing these countries ability to finance twin fiscal and external deficits.

Nonetheless, the threat of a full-fledged currency, sovereign-debt, and banking crisis remains low, even in the Fragile Five, for several reasons. All have flexible exchange rates, a large war chest of reserves to shield against a run on their currencies and banks, and fewer currency mismatches (for example, heavy foreign-currency borrowing to finance investment in local-currency assets). Many also have sounder banking systems, while their public and private debt ratios, though rising, are still low, with little risk of insolvency.

Over time, optimism about emerging markets is probably correct. Many have sound macroeconomic, financial, and policy fundamentals. Moreover, some of the medium-term fundamentals for most emerging markets, including the fragile ones, remain strong: urbanization, industrialization, catch-up growth from low per capita income, a demographic dividend, the emergence of a more stable middle class, the rise of a consumer society, and the opportunities for faster output gains once structural reforms are implemented. So it is not fair to lump all emerging markets into one basket; differentiation is needed.

But the short-run policy tradeoffs that many of these countries face damned if they tighten monetary and fiscal policy fast enough, and damned if they do notremain ugly. The external risks and internal macroeconomic and structural vulnerabilities that they face will continue to cloud their immediate outlook. The next year or two will be a bumpy ride for many emerging markets, before more stable and market-oriented governments implement sounder policies.

Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.