The Strange Case of the Missing Crisis

What emerging markets have—and haven't—learned from earlier downturns

By Greg Ip

No big emerging country has gone bust as a result of capital flowing out of emerging markets, Greg Ip writes.

No big emerging country has gone bust as a result of capital flowing out of emerging markets, Greg Ip writes. Photo: OMAR TORRES/Agence France-Presse/Getty Images
Capital has been flowing out of emerging markets for several years, driven by slowing growth, tumbling commodity prices, and the prospect of higher U.S. interest rates. Oddly enough, no big emerging country has gone bust as a result.

The absence of a crisis is not normally worth noting. But it is in this case, because it demonstrates how much the emerging world has learned about the inherent dangers of fixed exchange rates, and, sadly, how much more they still have to learn.

Emerging markets have long been major recipients of investment from foreign investors seeking to exploit their more promising economic potential. Yet such investment inflows are notoriously fickle, often slowing abruptly or reversing altogether.

In its semi-annual World Economic Outlook, the International Monetary Fund notes one episode of slowing capital inflows, from 1981 to 1985,  coincided with the developing country debt crisis of the 1980s, and another from 1995 to 2000 overlapped with the Asian crisis of 1997 to 1998.

The current episode of capital outflows began around 2010 and has been comparable “in breadth and size” to similar episodes in the 1980s and 1990s, the IMF says. But “the incidence of external debt crises in the ongoing episode has so far been much lower.” Indeed, no major emerging economy has needed a bailout except Ukraine, which was invaded by Russia, surely an extenuating circumstance.

In the past, emerging countries would fix their exchange rates to the dollar to control inflation and offer certainty to companies and investors. Interest rates at home were usually much higher than U.S. rates so domestic companies and governments could borrow more cheaply in dollars, so long as the currency peg held.

Foreign investors would meanwhile lend in the local currency, earning higher returns than they could in dollars, again only so long as the currency peg held. The belief in the currency peg thus perversely encouraged the accumulation of so much foreign currency debt that it made the peg more vulnerable.

As investors sensed the currency was overvalued (the usual consequence of inflation), they stopped lending. The withdrawal of foreign capital put so much selling pressure on the currency that it collapsed. Unable to repay their foreign currency loans, companies, banks or governments went bust.

In the past decade, emerging markets adopted orthodox macroeconomic policies. They told their central banks to focus only on inflation and staffed them with apolitical technocrats with PhDs from American universities. They floated their exchange rates.

Floating currencies made the cost of foreign currency borrowing less predictable, so countries did less of it. As the IMF notes, about 75% of emerging market government debt is now denominated in local currency, compared to zero in 1995, as is about 70% of emerging market corporate debt, compared to 5% in 1995.

“Flexible exchange rates appear to have helped some emerging markets mitigate the slowdown in capital flows so far by dampening the effects of global factors,” the IMF observes.

Floating exchange rates have produced a much more gradual adjustment to capital outflows, sparing emerging markets the “sudden stop” typical of prior eras. By contrast in Europe, the euro acted as fixed currency on steroids by funneling northern capital to southern economies.

When that capital fled, the eurozone experienced the mother of all sudden stops. It was Greece, a developed country, that defaulted, not a poor country. It was the U.S. and Britain whose banks nearly failed. As Guillermo Oritz, head of Mexico’s central bank, memorably quipped in 2008, “This time, it wasn’t us.”

So the encouraging lesson of recent years is that good macroeconomic policy can significantly reduce the frequency and severity of crisis. The bad news is that that is not enough.

The IMF notes that emerging market growth since 2010 isn’t much different from 1995 to 2000, despite the much reduced incidence of crises.  Brazil’s economy contracted 3.8% last year and could shrink almost as much this year, which would be a worse performance than during any of its crises of the last 36 years.

The reasons are multi-faceted ranging from declining commodity prices to high interest rates designed to bring down inflation. Underlying that poor cyclical performance are the structural problems of excessive regulation, inadequate investment, state-directed bank lending and corruption, problems that afflict most emerging markets to varying degrees.

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