Financial turbulence continues to surround the emerging markets, raising the question whether this now morphing into a genuine EM crisis, of the type seen in previous eras of Fed tightening, including the early 1980s, and 1994-98. If so, how will it progress?
I have asked three distinguished international economists to debate this with me. They are Maurice Obstfeld (University of California, Berkeley), Alan M. Taylor(UC, Davis) and Dominic Wilson (Co-Head of Global Economics, Goldman Sachs). Each has produced leading edge research on this topic in recent years.
The entire debate is attached
here, and I would encourage everyone interested in the subject to read it in full. However, since the text turned out to be fairly lengthy, I would like to offer here a summary of the main points which emerged.
Please contribute to any aspect of the debate in the comments section below.
Sudden Stop or Credit Crunch?
I have
previously argued that the current EM crisis is likely to be characterised by a domestic credit crunch in many economies, rather than a “sudden stop” in capital inflows, similar to that which occurred in the 1990s. The panel had some sympathy with this proposition, but argued that it was too simplistic.
Everyone agreed that most of the EMs are far better placed to withstand capital outflows than they were in the 1990s. DW and MO placed particular importance on the flexibility of exchange rates, replacing the fixed rate regimes of the 1990s. Along with credible inflation targeting, this should allow adjustments in real exchange rates without crises and implosions in market confidence.
AMT emphasised the structural advances in the EMs since the 1990s, saying “it is hard to overstate what a remarkable achievement it was” for the EMs to have survived the 2008 financial crash virtually unscathed. However, he warned that the scale of likely Fed tightening in this cycle may be unusually large, and he believed that the much greater weight of the EMs in the global economy might cause adverse feedback loops with the developed markets, which the DM central banks might be slow to recognise.
There was a clear recognition from the panel that there has been a very worrying build up in leverage and domestic credit in the EMs since 2008, and that this could cause major disruptions if local currency interest rates have to rise, and panic-driven capital outflows occur. AMT presented data which showed large rises in domestic leverage in China, South Africa, Turkey, some Baltic countries, Ukraine, Colombia, Brazil and India – a familiar cast list.
MO said that in these circumstances it would be difficult to separate a sudden stop from a domestic capital crunch, since the symptoms may be rather similar. DW said that “these may not be sudden stops in the classical sense, but their broader implications are not necessarily much different”.
There was considerable concern about the possible balance sheet mismatches that might be revealed in such circumstances, since previous crises have always uncovered problems in unexpected places. Thus, while DW argued that many EMs are better placed than they were a decade or two ago, we should “make that judgment with a good dose of humility”.
So my attempt to draw a neat distinction between these different types of problem was seen as only partially valid.
Hidden External Debt Problems
I asked about the
recent BIS paper which pointed to previously hidden external debt, and greater linkages between EM and DM interest rates. This has been worrying investors – did it imply that the underlying dangers are greater than we had recognised until now? The panel did not regard the new data as a game changer, but did emphasise the great uncertainties involved.
MO said that he remembered “sitting in an IMF lunch about 10 years ago, thinking hard about ‘What will cause the next crisis?’ We were basically at sea…we could spin scenarios but lacked the detailed information about financial linkages to know if any of our stories were plausible…No-one at the table suggested US sub prime lending.” He did however predict that “the real threat, as in every past big financial crisis, is leverage”, adding that many corporate sector carry trades could have been left unhedged, which might pose a major problem.
Optimism for Many EMs
There was a lot of optimism that many EMs would navigate the Fed’s exit well, because their policy responses would be appropriate. But there was concern about whether withdrawals of liquidity would put pressure on the available “lender of last resort” facilities. AMT pointed out that, although these facilities would this time be in domestic currencies, and therefore more readily available, “the reserve war chests sit on public balance sheets, while many of the incipient problems would lie on private balance sheets, so getting the backstops to where they might be needed in an emergency could present an interesting political economy problem”.
Both MO and DW wanted the developed central banks to offer new swap facilities to the EMs in order to prevent “self fulfilling losses of confidence” and currency runs, but no-one thought these swap lines were very likely to be implemented.
The “Correct” Policy Response
I asked whether the “correct” policy response by EMs to the developing situation should be more like an IMF-type package involving fiscal and monetary tightening, and structural reform (
“Fischer style”), or a World Bank-type package involving liquidity support from the DMs (
“Stiglitz-style”). The panel’s response was that the correct policy mix needed to vary according to circumstances, but there was clearly some sympathy with Stiglitz in arguing that tighter demand policy (fiscal or monetary) may not be appropriate this time.
Everyone emphasised that political responses and institutions would be crucial in separating the wheat from the chaff, with India and Indonesia receiving some praise. (Such praise was notably missing for Turkey, Brazil and Russia.)
China
AMT summed up the panel’s view very well when he said that China’s domestic leverage was a serious problem “but China has so much command/control that maybe they could “brute force” their way through with interventions, reserves etc.”DW added that it will “remain a difficult balancing act between discouraging risky lending practices without prompting a more rapid credit disruption” and concluded that “the task of rebalancing the economy is likely to be a long one”.
The panel did not see recent Chinese exchange rate policy changes as the start of prolonged currency weakness, which they thought would be a serious problem for other EMs if it did occur. MO warned that Chinese capital controls are “proving increasingly porous”.
Summary
I summarised the panel’s views as follows:
Without making any specific investment recommendations
[1], I would conclude from the debate that it is too early to get back into EM assets, though there would probably be some exceptions, in countries where the policy response appears to be best calibrated to the problems faced. The panel seems to think that China will engage in a very prolonged credit work-out, without major acute crises, while some other EMs might face crises, even though their external balance sheet problems seem much better than in the 1990s. That seems to be a difficult environment in which to make money from general long exposures to EM asset classes.
This summary does not do justice to the full text of the debate. A reminder: it is available
here. Please join in below.
