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With economic growth slowing significantly in many majormiddle-income countries and asset prices falling sharply across the board, isthe inevitable “echo crisis” in emerging markets already upon us? After yearsof solid – and sometimes strong – output gains since the 2008 financial crisis,the combined effect of decelerating long-term growth in China and a potentialend to ultra-easy monetary policies in advanced countries is exposingsignificant fragilities.
The fact that relatively moderateshocks have caused such profound trauma in emerging markets makes one wonderwhat problems a more dramatic shift would trigger. Do emerging countries havethe capacity to react, and what kind of policies would a new round of lending by theInternational Monetary Fund bring? Has the eurozone crisis finally taught theIMF that public and private debt overhangs are significant impediments to growth, and that itshould place much greater emphasis on debt write-downs and restructuring than it has in thepast?
The market has beenparticularly brutalto countries that need to finance significant ongoing current-account deficits,such as Brazil, India, South Africa, and Indonesia. Fortunately, a combinationof flexible exchange rates, strong international reserves, better monetaryregimes, and a shift away from foreign-currency debt provides some measure ofprotection.
Nonetheless, years ofpolitical paralysis and postponed structural reforms have createdvulnerabilities. Of course, countries like Argentina and Venezuela were extremein their dependence on favorable commodity prices and easy internationalfinancial conditions to generate growth. But the good times obscured weaknessesin many other countries as well.
The growth slowdownis a much greater concern than the recent asset-price volatility, even if thelatter grabs more headlines. Equity and bond markets in the developing worldremain relatively illiquid, even after the long boom. Thus, even modestportfolio shifts can still lead to big price swings, perhaps even more so whentraders are off on their August vacations.
Until recently,international investors believed that expanding their portfolios in emergingmarkets was a no-brainer.The developing world was growing nicely, while the advanced countries werevirtually stagnant.Businesses began to see a growing middle class that could potentially underpinnot only economic growth but also political stability. Even countries rankedtoward the bottom of global corruption indices – for example, Russia and Nigeria –boasted soaring middle-class populations and rising consumer demand.
This basic storylinehas not changed. But a narrowing of growth differentials has made emerging markets a bit lessof a no-brainer forinvestors, and this is naturally producing sizable effects on these countries’asset prices.
A step towardnormalization of interest-ratespreads – which quantitative easing has made exaggeratedly low – shouldnot be cause for panic. The fallback in bond prices does not yet portend a repeat of theLatin American debt crisis of the 1980’s or the Asian financial crisis of thelate 1990’s. Indeed, some emerging markets – for example, Colombia – had beenissuing public debt at record-low interest-rate spreads over US treasuries.Their finance ministers, while euphoric at their countries’ record-lowborrowing costs, must have understood that it might not last.
Yes, there is amplereason for concern. For one thing, it is folly to think that morelocal-currency debt eliminates the possibility of a financial crisis. The factthat countries can resort to double-digit inflation rates and print their wayout of a debt crisis is hardly reassuring. Decades of financial-market deepeningwould be undone, banks would fail, the poor would suffer disproportionately,and growth would falter.
Alternatively,countries could impose stricter capital controls and financial-marketregulations to lock in savers, as the advanced countries did after World WarII. But financial repressionis hardly painless and almost certainly reduces the allocative efficiency ofcredit markets, thereby impacting long-term growth.
If theemerging-market slowdown were to turn into something worse, now or in a fewyears, is the world prepared? Here, too, there is serious cause for concern.
The global bankingsystem is still weak in general, and particularly so in Europe. There isconsiderable uncertainty about how the IMF would approach an emerging-marketcrisis after its experience in Europe, where it has had to balance policiesaimed at promoting badly needed structural change in the eurozone and those aimedat short-run economic preservation. That is a topic for another day, but theEuropean experience has raised tough questions about whether the IMF has adouble standard for European countries (even those, like Greece, that arereally emerging markets).
It is to be hoped, ofcourse, that things will not come to that. It seems unlikely that internationalinvestors will give up on emerging markets just yet, not when their long-termprospects still look much better than those of the advanced economies.
Besides, the currentsentiment that the eurozone has gotten past the worst seems exceedinglyoptimistic. There has been only very modest structural reform in countries likeItaly and France. Fundamental questions, including how to operate a bankingunion in Europe, remain contentious. Spain’s huge risk premium has almostdisappeared, but its debt problems have not.
Meanwhile, across theAtlantic, the political polarization in Washington is distressing, with anotherdebt ceiling debacle looming. Today’s retreat to advanced-country asset marketscould quickly revert to retreat from them.
The emerging-marketslowdown ought to be a warning shot that something much worse could happen. Onecan only hope that if that day should ever arrive, the world will be betterprepared than it is right now.
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