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Satyajit Das: Is an Emerging Market Crisis Coming?

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Many now fear a rerun of 1994's Great Bond Massacre, which triggered emerging market crises and a 10-year setback to many Asian economies.

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1994 Redux

Battle-weary policy makers do not want to believe that an emerging market crisis is possible. Like former US Secretary of State Henry Kissinger, they believe, "There cannot be a crisis next week. My schedule is already full."

But there are striking resemblances to the 1990s. Then, loose monetary policies pursued by the US Federal Reserve and the Bank of Japan led to large capital inflows into emerging markets, especially Asia. In 1994, Federal Reserve Chairman Alan Greenspan withdrew liquidity, resulting in a doubling of US interest rates over 12 months.

In the 1994 "Great Bond Massacre," holders of US Treasury bonds suffered losses of around US$600 billion. Trading losses led to the bankruptcy of Orange County, California, the effective closure of Kidder Peabody, and failures of many investment funds. It triggered emerging market crises in Mexico and Latin America. It precipitated the Asian monetary crisis, requiring International Monetary Fund (IMF) bailouts for Indonesia, South Korea, and Thailand. Asia took over a decade to recover from the economic losses.

Many now fear a rerun, triggered by rapid capital outflows and a rising US dollar.

Weaknesses in the real economy and financial vulnerabilities will rapidly feed each other in a vicious cycle. Even if the reduction of excessive monetary accommodation in developed economies is slow or deferred, the fundamental fragilities of emerging markets -- the current account deficits, inadequate investment returns, and high debt levels -- will prove problematic.

Capital withdrawals will cause currency weakness, which in turn, will drive falls in asset prices, such as bonds, stocks, and property. Decreased availability of capital and higher funding costs will increase pressure on over-extended borrowers, triggering banking problems which feed back into the real economy. Credit rating and investment downgrades will extend the cycle through repeated iterations.

Policy responses will compound the problems.

Central bank currency purchases, money market intervention, or capital controls will reduce reserves or accelerate capital outflow. Higher interest rates to support currencies and counter imported inflation will reduce growth, exacerbating the problems of high debt. India, Indonesia, Thailand, Brazil, Peru, and Turkey have implemented some of these measures.

A weaker currency will affect prices of staples, including food, cooking oil, and gasoline. Subsidies to lower prices will weaken public finances. Support of the financial system and the broader economy will pressure government balance sheets.

The "this time it's different" crowd argue that critical vulnerabilities -- fixed exchange rates, low foreign exchange reserves, foreign currency debt -- have been addressed, eliminating the risk of the familiar emerging market death spiral. This is an overly optimistic view. Structural changes may slow the onset of the crisis. But real economic and financial weaknesses mean that the risks are high.

Fundamental weaknesses and a weak external environment limit policy options. The IMF's capacity to assist is constrained because of concurrent crises, especially in Europe.

Blowback

At the annual central bankers meeting at Jackson Hole in August 2013, Western policy makers denied the role of developed economies in the problems now facing emerging markets, arguing that the policies had "benefited" emerging markets. But developed economies now face serious economic blowback.

Since 2008, emerging markets have contributed around 60-70% of global economic growth. A slowdown will rapidly affect developed economies. Demand for exports, which have boosted economic activity, will decrease. Earnings of multinational businesses will fall as earnings from overseas operations decline. Investment losses will affect pension funds, investment managers, and individual investors. Loans and trading losses will affect international banks that are active in emerging markets.

Emerging markets have around US$7.4 trillion in foreign exchange reserves, invested primarily in US, Japanese, European, and UK government securities. If emerging market central banks move to sell holdings to support their weak currencies or the domestic economy, then the sharp rise in interest rates will attenuate the increase resulting from the reduction of monetary stimulus. This will result in immediate large losses to holders. It will also increase financial stress, adversely affecting the fragile recovery in developed economies.

Emerging market currency weakness is driving a rise in major currencies, such as the US dollar. This will erode improvements in cost structures and competitiveness engineered through currency devaluation by low interest rates and quantitative easing. The higher dollar would truncate any nascent recovery.

Over time, the destabilizing effect of national actions and complex policy crosscurrents may accelerate the move to closed economies, damaging the global growth prospects.

In reality, developed economies sought to export more than goods and services, shifting the burden of adjustment necessitated by the 2008 crisis onto emerging economies. Like a drowning man grabbing another who is barely able to swim, the policies may ensure that both drown together.
No positions in stocks mentioned.

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