Tag Archives: emerging markets

Shake, Rattle and Roll

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The selloff last week of the currencies of many emerging market countries while stock prices also declined can be seen as the result of “known unknowns” and “unknown unknowns.” How these will play out will become evident during the rest of the year. Either set of factors would be unsettling for the emerging market countries, but the combination of the two may lead to a long period of chaotic financial conditions.

The “known unknown” is the magnitude of the increase in U.S. interest rates following the scaling down of asset purchases by the Federal Reserve and the ensuing impact on capital flows to developing economies. A recent analysis at the World Bank of the response established a baseline assumption of an increase of 50 basis points in U.S. long-term interest rates by the end of 2015 and another 50 basis point rise in 2016. The European Central Bank, the Bank of Japan and the Bank of England would also relax their quantitative easing policies. The result, according to their model, would be a slow rise in global interest rates and a gradual tightening in capital flows to developing countries of about 10%, or 0.6% of their GDP. The biggest declines would occur in portfolio flows to these countries.

However, the World Bank analysts also allowed for alternative scenarios. If there is a “fast normalization,” then U.S. long-term interest rates will rise by 100 basis points this year and capital inflows to the developing economies drop by up to 50% by the end of the year. In the “overshooting scenario,” long-term rates rise by 200 basis points, and capital inflows could decline by 80%. These developments would raise the probability of financial crises in the emerging markets, particularly in countries where there have been sizeable increases in domestic credit fueled in part by foreign debt

But the U.S. is not the only source of anxiety for policymakers in emerging market economies.  A decline in Chinese manufacturing activity in January may be reversed next month, and by itself likely means little. The decline in Asian stock prices that followed the announcement of the fall, however, demonstrated the importance of China’s economy for the region, and why China’s economic performance is the “unknown unknown.” The financial system in China has become overextended, and the Bank of China has fluctuated between signaling that it would rein in the shadow banking system while also injecting credit when short-term interest rates rise. How long the authorities can continue their delicate balancing act is unclear.

The state of the financial system is only one of the aspects of the Chinese economy that raises concerns. Given the uncertainty about the impact of demographic and migration trends, the continuation of FDI flows, etc., any forecast is conditional on a host of factors.  The IMF reported increased growth in China at the end of 2013, but warned that it will moderate this year to around 7.5%.

The conundrum is that we do not know what we should be concerned about in China, whereas we can imagine all too well what may happen to financial markets in emerging markets following higher interest rates in the advanced economies. The result is likely to be continued declines in exchange rates and financial asset prices, as the vulnerabilities of individual countries are revealed. As Warren Buffet warned, “Only when the tide goes out do you discover who’s been swimming naked.”

Update: See Menzie Chin’s views on these issues here.

 

The Spirit of Versailles?

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The newly-approved U.S. budget bill did not include authorization for changes at the IMF in funding and quotas (see also here). Those measures require approval of 85% of the voting power of the IMF’s members, and since the U.S. controls 17.67%, the reforms cannot be enacted. This leaves the U.S and the Fund in difficult positions.

The IMF received loans from its members during the 2007-09, but has sought to convert these to increases in the quotas that provide the funding for the IMF’s lending programs. The IMF is not about to run out of money, but the opportunity to put its financing on a regular basis has been (at best) delayed.  The IMF’s members also agreed to shift quota shares, which also determine voting powers, to the emerging market nations while reducing the European presence on its Executive Board. China has made clear that it wants a larger voting share, and the other middle-income countries have taken a similar position. The postponement in increasing their quotas allows their governments to adopt a position of high dudgeon when the IMF next advocates policy changes in their countries. The Europeans, on the other hand, must be delighted that the they are no longer on the spot for obstructing the realignment.

What important Constitutional principle was at stake in the refusal of Congress to approve the measures? According to the New York Times, it was a lack of willingness to support multilateral financial institutions. This ties in with popular opposition in the U.S. to foreign aid, always a perennial target of right-want opprobrium, and it bodes poorly for the future. If a significant segment of political opinion consistently opposes U.S. involvement in international ventures and forums, then the U.S. will pay a price in diminished global influence.

Is it too dramatic to compare this event with the failure of the U.S. Senate to approve the Treaty of Versailles? Probably, but the similarities are suggestive of what is driving the rejection. A significant part of the American electorate was tired then of foreign wars and wished to retreat from foreign obligations, just as many do today. Anything that seems to support the financial sector is also viewed with suspicion.  Personal enmity between President Woodrow Wilson and Republican Senator Henry Cabot Lodge is echoed in the animosity between President Barak Obama and members of the Republican Congressional delegation. Lodge was concerned that the League would supersede the U.S. government’s ability to conduct foreign affairs, just as many contemporary conservatives are worried about the influence of the United Nations on domestic matters. Both Wilson and Obama have been accused of being unwilling (or unable) to persuade opponents of the need to approve the desired measures.

While the U.S. never joined the League of Nations, it is not about to leave the IMF. But the refusal to ratify the changes in the IMF’s governance will leave the U.S. vulnerable to the charge that it seeks to retain control of an organization that was established at the end of World War II long after its hegemonic position had ebbed. If this were the reason for these developments, it would at least be understandable from a realpolitik perspective. The truth may be more dispiriting: perhaps we do not understand what we have to lose.

Time For a Change?

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The imminent (or not) taper of purchases of securities by the Federal Reserve has resulted in a great deal of speculation about its effects on other countries. Among the more intriguing views that have been advanced is the claim that a withdrawal of foreign capital will lead to much-needed reform measures in emerging markets.  This is an interesting assertion, in part because it contradicts the meme that capital inflows act as a catalyst for “collateral benefits” that contribute to the establishment of better institutions. So, which is it—will a reversal of foreign money lead to an improvement in domestic governance or not?

The collateral benefits view was advanced after empirical analyses failed to find evidence that capital account liberalization contributed to economic growth. Then-IMF economists Ayhan Kose, Eswar Prasad, Kenneth Rogoff and Shang-Jin Wei (Prasad is now at Cornell, Rogoff at Harvard and Wei at Columbia) claimed that capital inflows promoted the development of the domestic financial sector, and contributed to institutional development, better governance and macroeconomic discipline. There was an intuitive appeal to this argument: shouldn’t foreign investors favor conditions that facilitate the development of local markets and institutions that lead to profits?

The problem is the (lack of) evidence for this linkage. Indeed, the wreckage of a decade of financial crises in Mexico, East Asia, Russia, Brazil, Turkey and Mexico suggested that foreign lenders had been blind to local conditions. Dani Rodrik and Arvind Subramanian, in their review of the arguments for financial globalization,  were unconvinced that collateral benefits could be found, and pointed to Turkey as a counter-example.

The second perspective builds off this contrasting view that capital inflows serve as a stopgap measure that allows recalcitrant governments to avoid implementing the reforms that domestic lenders demand. Easy money from aboard allows government officials to finance fiscal deficits that may include payments to supporters of the regime. Once the conditions that led to the inflows of foreign money disappear, the government is forced to deal with the domestic creditors.

Another version of this story sees capital inflows as contributing to bubbles in the country’s financial markets and institutions. A reversal of foreign money reveals the fragility of the domestic financial conditions and necessitates reforms. South Korea is sometimes cited as an example of a country that enacted economic and financial reform measures after its 1997-98 crisis that made the country better off.  Of course, a country pays a high price if a capital outflow occurs precipitously.

Recent concerns have centered on the “Fragile Five” of  Brazil, Indonesia, India, Turkey and South Africa. Their currencies depreciated when Federal Reserve Chair Ben Bernanke first raised the issue of cutting back on asset purchases last year. Increasing current account deficits in all but India have revealed a dependence on foreign capital. But it is India that most requires reform of the financial sector. Raghuram Rajan, governor of the country’s central bank, has sought to modernize the financial system, but faces political opposition and inertia. It would be unfortunate if he needed a crisis to get the attention of domestic politicians.