With few exceptions, most emerging market countries failed to regulate the surge in financial flows that poured into their countries like a tsunami in the wake of the global financial crisis. As capital now appears to be drying up, the foundations of growth and stability are in question across much of the developing world.
As emerging market and developing countries brace to prevent the worst, they may have to take bold action. If they do, they should be granted the flexibility to do so under international institutions and fickle capital markets.
In the wake of the financial crisis, financial flows stormed countries such as Brazil, Chile, Indonesia, South Africa, South Korea, Turkey, and many other emerging market and developing countries—into their currency markets, local bond and stock markets, banks, and beyond.
These countries were so attractive because they were feeding their commodities or manufacturing suppliers into the China growth miracle—a miracle that got a major post-crisis shot in the arm of a steroid-like stimulus package of 12 percent of GDP. Chinese demand, especially for commodities, created scarcity and speculation such that emerging markets gained not only from exports to China but also from a general rise in prices the world over.
If that wasn’t enough, financial flows were pushed out the door from the favorable interest rate differentials between emerging market countries and the United States. Low interest rates and quantitative easing were aimed to jump-start investment in factories, housing, and infrastructure projects in the US. Until recently, however, the US market was too risky for most investors. An easier bet was the ‘“carry trade.”
Banks and hedge funds borrowed in US dollars at low interest rates and purchased assets in higher interest rate countries such as Brazil where the differential was over 10 percentage points. If the ten percentage point profit wasn’t enough, investors bet against the dollar and for the emerging market currencies to further increase their lot.
According to the latest estimates by the Bank for International Settlements (BIS), emerging markets now hold a staggering $2.6 trillion in international debt securities and $3.1 trillion in cross border loans—the majority in dollars.
As the money was pouring in, exchange rates appreciated, making some firms think they then had even more collateral (and ever continuing demand and price increases) to take on more debt. Official figures put corporate issuance at close to $700 billion since the crisis, but the BIS reckons that the figure is closer to $1.2 trillion when counting offshore transactions designed to evade regulations.
And now the tides are turning. China’s economy is undergoing a structural transformation that necessitates slower growth and less reliance on primary commodities. Oil prices and the prices of other major commodities are stabilizing or on the decline. It should be no surprise then that many emerging market growth forecasts are continually being revised downward. Meanwhile, growth and interest rates are picking up in the United States. As the dollar gains strength, the value of emerging market currencies fall.
Many corners are saying we shouldn’t worry so much because most emerging markets have floating exchange rates that can absorb shocks, have developed local bond markets, and can use reserve pools and interest rate hikes to weather the storm.
Can we be certain that such policies are a guarantee? Many of the conventional tools to deal with these problems in emerging markets may not be adequate, and the appetite for unconventional tools is less evident than it was a few years ago. It is imperative to be aware of all the possibilities and to have all hands on deck.
Simply having a floating currency is no guarantee that a country can absorb external shocks. It is often assumed that countries with a floating currency can adjust to current conditions because their exchange rate will depreciate and exports will pick up.
This is far from a guarantee for at least two reasons. First, most emerging market debt is in dollars, so a falling currency means increasing debt levels since companies will need to come up with ever more local currency in order to pay dollar-denominated debts. That proves difficult in a slow growth environment.
Second, most countries didn’t properly invest their commodity windfalls into increasing the competitiveness of their industries, and thus exports may not pick up at all. An IMF study shows that while Latin America saw one of the biggest commodity windfalls in its history, it has the least to show for it in terms of savings or investment relative to other booms. What is more, the massive exchange rate appreciation that occurred as a result of the tsunami in short-term inflows deemed many industries uncompetitive and pulled them out of key global commodity chains.
Thus, weak currencies and more debt may lead to falling trader and investor confidence rather than surges in exports that will help countries adjust to the new shocks.
It is often noted that there is less risk given that some of the debt is from bond markets denominated in local currencies. However, most of the emerging market debt is still in dollars. And, more than three quarters of emerging market bond debt is held by foreigners—who are more likely to dump such debt when there are low growth prospects and better yields on distant shores.
Foreign exchange reserves are there for some countries that might face drastic declines in the value of their currencies—especially in East Asia. However, such moves are not always effective, as these reserves can deplete quickly, and many non-Asian countries will be more cautious in using those reserves given lower commodity prices looking forward.
Raising interest rates to attract capital could have adverse effects as well. If not done carefully, or in the presence of regulating capital flows, interest rate hikes are likely not to turn the tide toward the U.S. market and can choke off what little growth is to be had in emerging markets during the downturn.
Regulating the outflow of capital may be a bold choice that countries may need to resort to. Such moves often trigger an over-reaction from pundits, the IMF, and capital markets. Worse, regulating capital is increasingly illegal under international trade and investment treaties—especially those with the U.S.
The biggest lesson here is that emerging markets need to regulate the inflow of short-term capital flows in order to avoid being in such a predicament in the first place. Although the IMF even partially came to that view in 2012, few countries were prudent enough to regulate the tsunami.
As I show in my new book, Ruling Capital: Emerging Markets and the Reregulation of Cross-border Finance, two exceptions were Brazil and South Korea. Both countries invented innovative regulations on foreign exchange derivatives after the crisis in an attempt to stem the harmful impacts of short-term inflows. South Korea’s regulations have proved to be more effective because they were more stringent and in an environment where derivatives markets were over-the-counter and deliverable. Brazil’s regulations had some positive impacts but were relatively timid and more easily circumvented through Brazil’s offshore markets.
Unfortunately, however, too many countries failed to act and instead let capital flows storm into their countries to bloat balance sheets and currency values. They are left with increasing debt as currencies slide and not enough competitiveness to benefit from currency depreciation. The result could be more financial instability that could further threaten prospects for growth and employment.
Emerging market and developing countries should do more than simply brace themselves for a bumpy ride. They should put in place permanent and counter-cyclical regulations on the inflow and outflow of capital. Alongside more conventional tools these measures have proven to help avoid and mitigate the worst that financial instability has to offer.
With the exceptions of nations like South Korea and Brazil, most have been too timid to regulate. They face powerful interests at home and abroad against reregulation and are receiving less backup from international institutions. Whereas the IMF was actively advocating for conventional and unconventional approaches during the capital inflow surge, they are relatively silent now.
As the United States pursues the Trans-Pacific Partnership Agreement with Pacific Rim nations—which if passed would be the biggest regional trade and investment deal between industrialized and developing countries in the world—it continues to insist that regulating cross-border financial flows would be illegal and that private investors would be able to directly sue governments that tried.
Chile and Malaysia, both party to the negotiations, have been credited for innovative regulations on the inflow and outflow of capital that have helped those nations prevent and mitigate financial crises. At this writing the U.S. has resisted efforts to allow nations to regulate inflows or to even have a balance-of-payments exception that would allow nations to take emergence measures during a crisis.
It is paramount that nations consider and be granted the flexibility to use all tools possible—both conventional and unconventional—in order to navigate the storm. If we have learned anything from the global financial crisis it is that instability anywhere can lead to instability everywhere.