Published: 27 January, 4:02 AM
Emerging-market economies had a brutal week. For years, during the crash and its aftermath, they did well as the advanced economies slumped. Recently, not so much.
Many developing countries are seeing their currencies drop and their bonds and equities hammered. Just as the global recovery appeared to be strengthening, a fresh source of instability has presented itself.
The issue now is how to keep the turmoil from derailing the global expansion. In a way, this was not an unexpected development: The recession in the advanced economies caused central banks to push short-term interest rates to zero and buy assets to drive long-term rates down as well. Capital flowed to the developing world in search of better returns.
As investors prepare for a resumption of normal monetary policy, demand for emerging-market assets is bound to fall. The question has always been whether this adjustment would be smooth or abrupt.
The problem is that two things are amplifying the adjustment of capital flows: First, the dependence of global capital markets on the dollar, and hence on the policies of the United States Federal Reserve; and second, policy mistakes in some of the most-watched developing economies.
In the short term, there is little to be done about the dollar’s destabilising pre-eminence. But economic reform in some of the main emerging-market economies, desirable in its own right, would help calm nerves.
Paradoxically, the US market crash of 2007 and 2008 entrenched the dollar’s global dominance. Investors sought safety, and US government debt remains the world’s safest asset. Despite tremendous federal borrowing, US debt was soon in short supply.
The Fed’s quantitative easing (QE) took trillions out of the market, and emerging-market governments bought dollars as a cushion against bad news and to hold their currencies (and export prices) down. As a result, the emerging markets are unduly sensitive to fluctuations — real or imagined — in US monetary policy.
The Fed has recently begun to pivot away from quantitative easing, signalling that the era of extraordinarily loose US monetary policy will come to an end. This is making investors think twice about putting their money in developing countries.
The Fed has begun to taper QE too soon — inflation in the US is still low and the labour market is still slack. On the other hand, the reduction in the pace of asset purchases is gentle (some would say to a fault) and, at some point, winding down the Fed’s unorthodox measures was going to be necessary. The remedy for undue global sensitivity to US monetary policy is not a different approach by the Fed; rather, it is burden-sharing. Eventually, other currencies, such as the euro and the yuan, need to function alongside the dollar as reserve currencies.
In the meantime, better US fiscal policy — less budget contraction now, when the economy needs stimulus, and more later — would also lighten the Fed’s load.
THEIR OWN FAULT
There is also more that emerging-market governments can do. They should recognise that last week’s financial-market turmoil was, to varying degrees, their own fault.
Argentina, which felt the full force of the storm with collapsing bond and equity prices and a steeply devalued peso, is a textbook case of economic mismanagement.
No mistake has been left unmade — including cooking the books about the true rate of inflation.
There is news to concern investors in other and more important emerging markets, too. Growth in China has been expected to slow for years. It now appears to be happening, and the government’s ability to manage the necessary economic restructuring is in doubt.
The world’s second-worst-performing currency lately is the Turkish lira: Political protests, corruption scandals and flailing leadership are calling the country’s economic prospects, and its place in Europe, into question. Russia is stumbling. So is Brazil.
Suffice to say, the best way for emerging-market governments to restore confidence would be to improve their policies. In last week’s financial turmoil, factors beyond their control were in play, but they are not innocent bystanders, and they are not powerless. BLOOMBERG