An old movie is playing in emerging markets

But vulnerability to foreign funding need not mean an unhappy ending


In the second quarter, emerging markets currencies had their worst fall against the dollar in seven years © Bloomberg


If it walks and quacks like an emerging markets balance of payments crisis, is it really an emerging markets balance of payments crisis? We are not yet there, and hopefully it will not come to one. But the patterns recently displayed by global financial markets are sufficiently redolent of capital flight from poorer countries in the past that caution is in order.

Start with foreign exchange. In the second quarter emerging markets currencies had their worst fall in seven years. July started better, but the downward pressure is back on a steady course of interest rate tightening in the US. This attracts capital to the dollar.

Equity investors have been pulling money out of emerging markets for 10 weeks straight. So have bond investors, though that outflow appears to have been staunched — for now.

Seasoned market watchers have seen this movie many times before. In times of low global interest rates, emerging markets are flooded with cheap lending from the rich economies, reflected in large current account deficits.

The debt that accumulates as a result, especially when denominated in hard currency, lands them in a zone of instability where a reversal of capital flows can violently disrupt creditworthiness and economic activity. Fears of exactly this phenomenon can be enough to trigger the reversal.

With so much painful history to recall — the Latin American debt crisis in the 1980s, the “Tequila” and Asian financial crises in the 1990s — emerging countries should have learnt not to fall into the same trap again. And some have indeed done just that.

On many measures, macroeconomic performance is better — for emerging markets as a whole, inflation rates are at historic lows. Governments are nowhere near as indebted as in advanced economies. And markets have become more discriminate, differentiating between countries and rewarding those that seem to be managing their economies well.

Where there is danger, it resides in the private sector: emerging market companies now carry more debt as a share of their countries’ economic output than their counterparts in rich countries. At a 94 per cent debt-to-GDP ratio, up from 63 per cent in just a decade, capital flight could stop an exposed country’s growth in its tracks.

A debt crisis, moreover, is no less political for originating in the private sector: as Argentina and Turkey have both shown in recent months, financial brittleness can quickly threaten political credibility.

What can emerging country policymakers do? Ideally they would not start from here. It is crucial to manage well the capital inflows in the boom: using tax and regulatory tools to favour direct investment or equity over debt; put in place moderate capital controls up front (so investors are not caught unawares) to stem outflows in a crisis; and make the domestic economy resilient to a changed environment. That can mean limits on leverage and policies to channel foreign funds into productive investments.

This advice is admittedly of limited use to those already exposed to capital flight. But they are also not bereft of protective policy tools. They can minimise the pain of a refinancing crisis — which would also make one less likely — by incentivising a switch into longer-term funding.

They can streamline the domestic framework for private-sector debt restructuring. If capital heads for the door, they should not waste too many resources defending exchange rates, especially at the cost of stifling growth with high interest rates. Growth is, after all, the best solution to debt, for debtors and their creditors alike.