Don’t let emerging markets be the ‘something that breaks’

The Fed is stirring a perfect storm and EM policymakers must act while they can

José Antonio González

The US Federal Reserve in Washington, DC. Emerging markets are "price takers" of US monetary policy © Reuters

Ever since the Great Depression, with only two exceptions, every time the US Federal Reserve has gone through a monetary tightening cycle, something in the world economy has broken — the bankruptcy of a major bank, a localised banking crisis, or an outright, full-fledged financial crisis. And ever since emerging markets became more integrated into the world’s financial markets, they have tended to be centre stage.

A Fed tightening cycle preceded the debt crisis in Latin America in 1982, the Mexican crisis in 1995, the dotcom bubble in 2000 and the global financial crisis of 2008-09. Although rates did not rise at the time, one could argue that the Asian and Brazilian crises of the late 1990s were in part due to the that fact interest rates remained relatively high.

The transmission mechanism is well understood. In a nutshell, the Fed sets interest rates for the dollar and, the dollar being the world’s reserve currency, this determines the cost of money worldwide. When the Fed increases rates, the cost of money rises, investment decreases and the economy slows down.

In emerging markets, there are typically two additional effects when interest rates rise. First, risk-adjusted rates of return become less attractive, causing a reversal of capital flows, in turn leading to more than proportional increases in local interest rates (known in the international parlance as spread decompression). This further decreases investment and complicates new financing and debt rollovers for governments and firms. Second, the slowdown typically causes a drop in commodity prices, which can have a large impact on certain economies.

But let’s be clear, this is not the Fed’s fault. Although it is sensitive to the repercussions of its policy decisions, the Fed has its own clear monetary mandate. Emerging market economies are “price takers” of monetary policy from the Fed and should adjust accordingly.

This brief historical recap is relevant today because there are various elements in the macroeconomic financial conditions worldwide that are coming together to form a particularly difficult juncture and, if not a perfect storm, certainly a pretty good one.

First, the Fed began a new monetary tightening cycle in 2015. It has included nine hikes, and market participants are expecting more, although there is a debate as to how fast and how high interest rates will rise. Admittedly, by historical standards, the levels are still low, at 2.25-2.5 per cent, but the trend is clear.

Second, increases in the Fed’s rate have caused the term spread (the difference between short and long-term interest rates) to flatten to around 0.13 percentage points — comparable to levels observed before the onset of the 2008 financial crisis. History shows that an inversion in the term spread is a good predictor for a recession in the US. Since World War II, every time the term spread has inverted, a recession has followed — with only one exception, when there was not a recession but a deceleration.

The third element is that trade tensions could damage global and domestic activity as well as confidence. Since April 2018, stock performance of firms exposed to trade have underperformed by as much as 8 per cent compared with the S&P 500. Moreover, the IMF has warned that current trade tensions risk lowering global growth by as much as 0.5 per cent by 2020, or about $430bn in lost GDP worldwide.

In short, if these factors come together simultaneously they could have a huge impact in emerging economies. A looming recession or deceleration in advanced economies will lower export demand, which, coupled with trade tensions, will probably cause commodity prices to fall, hurting export-dependent emerging market economies. Rising interest rates in the developed economies will cause capital flow reversals from emerging markets, which we began to observe in 2018, making refinancing and debt rollovers more difficult.

There is a silver lining, however: the storm is not here yet. The two largest economies, the US and China, still show robust growth and, perhaps more importantly, the Fed recently indicated that it may raise rates more gradually. Policymakers in emerging markets have time.

There are no magic bullets. The best course of action is to make sure the basic macroeconomic indicators are in order:

1) Fiscal accounts need to be balanced in at least two dimensions: fiscal deficits need to be lowered or outright eliminated, as access to financing will become more difficult; and the debt profile needs to be improved by opting for domestic rather than foreign debt, fixed rather than flexible rates, and longer maturities.

2) External accounts also need to be balanced. The current account should be close to equilibrium because, even if fiscal accounts are in order, external imbalances can be a source of vulnerability and cause a foreign exchange crisis.

3) Monetary policy plays a crucial stabilising role in the face of volatility. It should be conservative both to ensure price stability and to avoid sudden capital flow reversals. At the same time, central banks in emerging markets face a limit to how much to defend the flow of capital, and a commitment to free-floating exchange rates is paramount. Fixed exchange rate regimes have proved costly in the past.

4) Finally, the financial sector must be well capitalised, liquid, not overly exposed nor be the cause of an asset bubble (especially in real estate). It is important not only to look at banks but also at non-bank financial intermediaries, particularly now that inclusion in the financial sector has been actively promoted through fintech and financial innovation.

If the measures outlined come from such basic macroeconomic principles, the obvious question is, why have emerging economies been caught off guard so many times in recent history? The answer is not clear, but let me propose two possible explanations:

First, prudent macroeconomic policies are not popular or easy to implement anywhere, but especially in emerging economies: Fiscal deficits allow greater public spending on social programmes; current account deficits are typically associated with overvalued exchange rates, which make imports and the goods and services we buy abroad cheaper; and financial regulatory forbearance implies that credit is more widely available. The problem is that all of these conditions are temporary and not sustainable.

Second, macroeconomic financial institutions are less mature in emerging markets: central banks and financial regulators are not as independent and as capable as in developed countries, fiscal rules and budget laws are not as solid and, therefore, do not insure long term fiscal sustainability and transparency.

But there is time for emerging markets to prepare for what is coming. Now is not the time to doubt prudence and test the will and ferocity of the worlds’ financial markets. Now is the time to adopt prudent macroeconomic policies to make sure that our economies are resilient to the headwinds that will surely become stronger. In other words, to make sure that the “something in the world that breaks” is not the emerging markets.

José Antonio González is a former Minister of Finance of Mexico.

Mario Draghi’s Last Try

Don’t blame the ECB for the recession menacing the eurozone.

By The Editorial Board

Mario Draghi, President of the European central Bank attends a news conference on the outcome of the Governing Council meeting at the ECB headquarters in Frankfurt, Germany, March 7, 2019.
Mario Draghi, President of the European central Bank attends a news conference on the outcome of the Governing Council meeting at the ECB headquarters in Frankfurt, Germany, March 7, 2019. Photo: kai pfaffenbach/Reuters

Just when Mario Draghi thinks he’s on the path to monetary normalization, the failures of European leaders drag him back to center stage. The eurozone is flirting with recession, a banking crisis always seems to beckon in Italy, and with a few notable exceptions elected leaders have ignored the European Central Bank president’s pleas for economic reform. So it’s Mario to the rescue one more time.

On Thursday he tweaked the central bank’s “forward guidance” to push an interest-rate increase into 2020 at the earliest, after previously suggesting one might come this year. He also unveiled more targeted long-term refinancing operations—TLTROs—to provide cheap funding to European banks until 2023. And lest there was any doubt, the ECB will roll over in full maturing bonds acquired under its €2.6 trillion quantitative-easing program.

Mr. Draghi would have been hard-pressed to do nothing. ECB economists have cut their economic growth forecast for 2019 to 1.1% from the 1.7% they had expected in December. Central bank staff now expect inflation of 1.2%, down from the 1.6% they predicted three months ago and well short of the ECB’s near-2% mandate. Even those guesses could be optimistic given sagging confidence indicators, China’s unfolding slowdown and President Trump’s trade wars.

Yet recent years also have demonstrated the limits of Mr. Draghi’s extraordinary exertions. Despite QE, a negative deposit rate, and multiple subsidies for banks, the eurozone never managed to boom. Growth peaked at 2.4% in 2017, and unemployment rates as high as 15% (Spain) and 11% (Italy) linger.

Mr. Draghi understood the ECB’s limits and begged European leaders to reform labor laws and business regulations under the political cover of his monetary policy. Only France’s Emmanuel Macron has heeded the call, and now his agenda is endangered by the popular backlash to his green-tax overreach. Europeans scorned the tax reform and deregulation that lifted America’s growth.

Which brings us to Mr. Draghi’s TLTRO extension. The program, entering its third iteration, provides cheap funding to banks with incentives to lend to small businesses in particular. At the peak, European banks had gobbled up €740 billion from two TLTRO rounds, and some €720 billion of that is still outstanding, due to be repaid starting in June 2020.

The problem is that those earlier TLTROs risk amplifying rather than ameliorating Europe’s reform failures. Italian banks were especially vulnerable to the looming end of TLTROs because they’d taken up an outsize chunk of the funding—some 33%, according to UBS .Italian institutions rely on that money to finance lending, with TLTROs accounting for about 17% of loans compared to the eurozone average of 7%. Naturally, this funding counted as “safe” under various European regulatory measures.

With the first two TLTROs ending, fragile Italian banks would have struggled to find other funding sources. They still labor under substantial bad debts, and the policies of the left-right insurgent coalition now in power in Rome are driving up Italian borrowing costs. Mr. Draghi can’t admit Thursday’s action is designed partly to forestall a new banking crisis in Italy, but that’s an obvious benefit.

Mr. Draghi must be frustrated that he never weaned Europe off its overreliance on his monetary pyrotechnics, and he may have inadvertently made parts of the eurozone economy more vulnerable. As he heads to the end of his ECB term in October, his last monetary try at least puts the onus of recession on the politicians where it belongs. This won’t be enough to revive Europe’s sagging fortunes—and, to Mr. Draghi’s credit, he never claimed otherwise.

Trump’s Imperial Overreach on Trade

As part of its effort to contain its main global rival, the US is trying to secure the power to prevent the United Kingdom and the European Union from so much as negotiating trade agreements with China. Although a post-Brexit UK will probably have little choice but to follow Canada’s lead and comply, the EU is big enough to say no.

Daniel Gros 

LOS ANGELES – Two recent developments are bringing America’s trade strategy toward China into focus. The first, which affects bilateral trade negotiations, is no surprise: US President Donald Trump has abandoned his bluster for vague promises – to enforce property rights, loosen restrictions on foreign investment, and stop pressuring foreign companies to share their technology – that China has made before. The second development, which concerns America’s allies, is more revealing – and treacherous.

In the last few months, the Trump administration has released its negotiating objectives for a possible trade agreement with the United Kingdom after Brexit, as well as future talks with the European Union. Most of those objectives are not particularly surprising; they seek to maximize access to UK or EU markets, while protecting sensitive US sectors. But they do include one highly unusual provision.

In its document on the EU, the US states its intention to secure “a mechanism to ensure transparency and take appropriate action if the EU negotiates a free-trade agreement with a non-market country.” The “non-market country” is no doubt China. If the EU agrees to this demand, it would have to inform the US – which would have the right to intervene – even if it is merely negotiating a trade deal with the world’s second-largest economy.

This objective has to be taken seriously, because the US had a similar clause added to the revamped North American Free Trade Agreement, now called the US-Mexico-Canada Agreement. In fact, the USMCA clause is even stricter, because it gives the US the right to intervene even earlier, when Canada so much as intends to start trade negotiations with China.

Asking a trading partner to ensure “transparency” when they negotiate with other countries may sound innocuous, but it represents an unprecedented level of interference in partner countries’ trade policymaking. Trade negotiations are already arduous, protracted affairs, not least because they involve easing protection of politically sensitive sectors.

Adding an unrelated third party to the proceedings – especially one whose intent might be to torpedo the negotiations – would make success even less likely. Moreover, action the US would deem “appropriate” if the EU started negotiating a free-trade agreement with China would presumably include the threat of tariffs against European exporters.

The EU currently has no intention of entering into a free-trade agreement with China. But, as a matter of principle, it is highly unlikely to accept such a clause. And, given that the EU is actually a bigger global trading power than the US, it is in a position to say no.

A post-Brexit UK, however, will probably have little choice but to follow Canada’s lead and hand the US an effective veto on its trade policy towards China. In the UK, Brexiteers used the slogan “Take Back Control” in campaigning to leave the EU. However, with these US demands, the UK will lose its autonomy over trade policy. The dream of a “Singapore-on-Thames” is unlikely to materialize.

There can be no economic justification for the US to object to one of its allies concluding a free-trade agreement with another country, even one without a pure market economy. Economic analysis has shown that regional trade agreements can have ambiguous effects on third countries. This is why such deals are subject to Article XXIV of the World Trade Organization (WTO), which says that regional free-trade agreements should cover “substantially all the trade” between the relevant partners. This bar might be difficult for the EU and China to clear, given that both still have rather protected agricultural sectors. The US could thus air any legitimate complaint about an EU or UK deal with China through existing WTO channels. This is yet another example of how the US could use the multilateral trading system to its advantage, instead of undermining it.

But the US attempt to control its allies’ trade policy toward China is not driven by economic considerations. Rather, it represents a geostrategic effort to isolate China, thereby giving the US more leverage with its main global rival.

This is not the first time that economic weapons are being deployed in a great power rivalry. At the beginning of the nineteenth century, the French army had vanquished most other powers on the European continent. But Napoleon could not force his will upon the pesky British, whose navy dominated the seas and who had the financial resources to support his enemies. So, in 1806-07, at the peak of his military success, Napoleon erected the so-called Continental Blockade, forbidding any territory he ruled from trading with Britain.

The blockade proved extremely difficult to enforce, even in France, where smuggling proliferated. Worse, by forcing all of his allies to bend their trade policy to his will, Napoleon inadvertently fueled hostility to his rule, especially in Northern Europe, where trade with Britain had played a vital role in the local economy.

Yet Napoleon was so obsessed with enforcing the blockade that he forced even Russia – the only power he had not defeated – to agree to it as a condition of peace. This proved extremely costly for Russia, which eventually disregarded the blockade and reopened its ports to the British. Napoleon took this as a casus belli and invaded Russia. The rest, as the saying goes, is history.

Napoleon’s imperial overreach was his undoing. If Trump sticks to his current course on trade policy, the US may well face a similar fate.

Daniel Gros is Director of the Center for European Policy Studies.

Cuba’s Shifting Geopolitics

The island’s role in the geopolitical system has evolved over time.

Allison Fedirka  

The United States’ animosity toward Cuba seems a matter of course. So, it came as no surprise when Congress passed legislation this week that allows U.S. companies to sue Cuban entities.

Over the past 125 years, however, the U.S. and Cuba have shifted from close allies to sworn enemies. Washington has provided military support to independence movements and invested in Cuba’s development. It has also backed dictators, blocked missiles, executed covert operations and imposed sanctions on the island.

As global power dynamics have shifted, so too have Cuba’s importance and its relationship with Washington – illustrating that while a country’s geography is constant, its role in the geopolitical system evolves over time.

Cuba Then
Cuba is the largest island in the Caribbean and lays at the confluence of the Atlantic Ocean, the Gulf of Mexico and the Caribbean Sea. Spain, recognizing the island’s geopolitical importance, colonized Cuba and brought it into the global system in the 16th century – a time when European powers were competing in a massive land grab in the Western Hemisphere. The Spaniards built the island into a regional logistics and military hub; it was well-positioned to resupply ships after the long Atlantic crossing, launch voyages to other colonial holdings in the hemisphere and enable Spain to protect its holdings from other European states. By the 19th century, Spain’s power in the New World began to dwindle, but Cuba’s importance did not.


In the late 19th and early 20th centuries, Cuba played a critical role in the United States’ emergence as a regional power. The U.S., triumphant in the Mexican-American War, had expanded westward, showing great potential to become the dominant regional power. But shortly thereafter, the U.S. descended into civil war and a period of reconstruction, both of which drained the young country’s resources and attention, forcing it to turn inward. When it managed to emerge intact, the U.S. set its sights on regional expansion. With a territory that stretched coast to coast, this meant turning to the seas.

The United States was operating on the notion that if it controlled the oceans it could harness regional and potentially global power. Controlling Cuba was a key part of this strategy. The U.S needed to expel foreign powers (particularly Spain) from its environs, form a security belt through its southern waters and open an east-west maritime corridor in the Caribbean. A base in Cuba, which lies about 100 miles (160 kilometers) south of Florida, would help the U.S. defend its coastal waters, safeguarding access to the Atlantic for its Gulf of Mexico ports. Cuba would also serve as a foothold from which the U.S. could establish a defensive perimeter and expand farther. To this end, the U.S. military intervened in 1898 to support the Cuban fight for independence from Spain in what would become known as the Spanish-American War. The Cubans – and their American backers – prevailed and Cuba, along with Puerto Rico, became a de facto U.S. territory. The U.S. had its foothold, and its status as the dominant North American power was secured.

With the onset of the two world wars, Cuba’s prominence in regional geopolitics subsided. As of the early 1900s, European powers were no longer pursuing territorial claims in the Western Hemisphere. Instead, the major threats to U.S. interests, the great wars, were in Europe itself. U.S. resources were funneled toward supporting allies and, later, combating the Central and Axis powers. The U.S., therefore, modified its approach to the island, keeping Cuba under control by maintaining strong economic ties, supporting political movements and installing leaders whose policies aligned with U.S. interests.

Cuba’s import returned with a vengeance during the Cold War. In 1959, following years of guerrilla warfare, Fidel Castro ushered in his Cuban Revolution and took control of the country. The U.S. had lost its grip on the Cuban government but held onto its naval base in Guantanamo Bay, preserving a fragment of the U.S. foothold and a threat to the Castro regime. Castro, who despised the United States, quickly aligned his government with the Soviet Union. For Moscow, having a Soviet ally located so close to the United States’ mainland proved invaluable. The U.S. was stationing nuclear weapons in its allies’ territories along the Soviet border, and with Cuba on its side, Moscow could do the same. Cuba opened itself to Soviet military equipment and installations, posing a major strategic threat to the U.S. That threat culminated in the 1962 Cuban missile crisis, during which the U.S. and Soviet Union teetered on the brink of nuclear war, which could very well have been triggered by missiles launched from proxy states. This was Cuba’s 15 minutes of geopolitical fame, placing it at the center of the global system. Of course, the threat was defused, and while U.S.-Cuban enmity persisted for the remainder of the Cold War, it did not reach crisis levels again.
Cuba Now
A generation has passed since the end of the Cold War, and Cuba is far less important to the global system than it once was. The Cuban economy collapsed as the Soviet Union fell, and it has never recovered. No major outside power – like Russia or China – currently has the will or resources to build up a military presence in Cuba, and the U.S. has the naval capabilities to control regional waters without physical holdings there. Still, Washington can’t ignore it altogether. The U.S. can stop Cuba from posing a threat by keeping it weak and limiting foreign influence through a lower-cost, hands-off approach. The Obama administration went so far as to reopen diplomatic ties with the island, signaling that while Cuba and its communist regime posed no real threat, improved relations wouldn’t hurt. Cuba’s regional geopolitical importance is decreased but not erased.

In recent months, Cuba has played a role in the unfolding crisis in Venezuela as Cuba’s security forces stand firmly behind embattled Venezuelan President Nicolas Maduro. It is in this context that the U.S. government announced on March 5 that it will allow U.S. citizens and companies to sue Cuban entities over contested property rights on the island. (This comes just months after the Trump administration moved to sanction more Cuban businesses with ties to the government and military.) Out of the options for recourse that the U.S. has available, this one is relatively mild. The potential lawsuits will buttress economic sanctions and restrictions already in place against Cuba, but this move won’t have any immediate impact on Cuba – it will take years for courts to rule on any suits filed. The decision does, however, raise the level of uncertainty for doing business on the island in the medium term and may cause much-needed investors to reconsider putting their money there. 

Notably, the U.S. held off from allowing the lawsuits to be filed against foreign firms with ties to contested property in Cuba. This minimizes the impact on third-party countries, especially some of Cuba’s largest trading partners that are also U.S. allies, including European states and Canada. The U.S. embargo on Cuba has been in place for decades, but Washington hasn’t objected to Canadian and European trade and business that feed the Cuban economy. And it’s not ready to needlessly antagonize those allies now. Washington and Ottawa still need to ratify the United States-Mexico-Canada Agreement on trade. The U.S. needs its allies in Europe to combat the threats from Russia and Iran and to iron out pending differences over major trade issues like automobiles. These are more pressing concerns than bickering over Cuba. The U.S. feels no pressure to force immediate change in Cuba and can afford to play a long game.

Cuba will always fall under the umbrella of U.S. interests. As needs dictate, the U.S. may ramp up or scale back its engagement, dedicating more or fewer resources to its relationship with the island depending on what’s at stake. Cuba’s waxing and waning geopolitical importance shows just how much a country’s strategic relevance is shaped by changing regional and global dynamics over time.