Emerging Markets face a Faustian bargain. For years, they were advised that greater integration with international financial markets is a good idea. A developing country that opens itself to investment from abroad, whether through portfolio flows or foreign direct investment, will lower its cost of capital and accelerate the investments it needs to make in productive assets such as roads, power plants, and ports. On the other hand, recent economic research suggests that the countries that faced the brunt of investors ‘rebalancing’ their exposure to emerging markets—in response to the Federal Reserve announcing its intention in the second quarter of 2013 to phase out its quantitative easing (QE) program—were the ones with the deepest and most liquid financial markets.[i] A case of damned if you do, damned if you don’t?
There are two broad schools of thought as to why emerging markets are facing such pressures. Writing for the New York Times, the Nobel prize winning economist Paul Krugman argues that wealthy countries such as the United States have done too little to combat sclerotic growth in the aftermath of the crisis.[ii] While the Fed’s extraordinary policies helped stave off a second Great Depression, private investment has remained moribund in the absence of concerted fiscal action. If policymakers had acted more forcefully to restore growth instead of prematurely worrying about debt, the US economy would have been much healthier, creating greater demand for emerging market exports and increased investment abroad.
Dani Rodrik, of Princeton University, and Arvind Subramaniam, at the Peterson Institute, eminent economists both, have a slightly different take.[iii] They argue that emerging markets should have known what they were getting themselves into when they liberalized their financial markets in the first place and allowed themselves to be exposed to fickle capital flows. Emerging markets have no right to complain once they open the floodgates and proceed to pursue policies that are bound to create volatility: running large fiscal and current account deficits, in addition to not following prudent macroeconomic policies to prevent their currencies from appreciating and becoming overvalued in the first place.
In order to parse through these arguments, it is necessary to understand how these countries got here in the first place. The years preceding and following the financial crisis were extraordinary by any measure, especially so for emerging markets. Between the years 2003-2007 emerging markets grew at an astounding average of 7.7% a year. These were heady years, with much talk of countries like China, Brazil, India, South Africa and others following a path of convergence to the living standards of the industrialized world in a few short decades, very much within our lifetimes. Private capital flows as a percentage of developing world GDP, which had averaged about 4% in the 1990’s, peaked at 12% in the third quarter of 2007.[iv]
The 2008 crisis brought a sudden and abrupt shock, with investors pulling out their money out in favor of the security offered by US Treasury Bills at a time of great uncertainty. Private capital flows to emerging markets were negative in 2008 before they rebounded again; averaging 6% of developing countries’ GDP from 2010 to 2013 (see Figure 1).[v]
Figure 1: Private Capital Flows to Emerging Market Countries
Source: World Bank 2014
As the US economy gradually began to recover, the Fed indicated in May 2013 that it was considering a gradual unwinding of its QE program leading to a rise in US government interest rates and a significant adjustment in the portfolios of global investors who began to pull their money out of emerging markets causing downward pressure on their currencies and asset prices (see Figure 2). The World Bank estimates that investors withdrew $64 billion from emerging market funds between June and August of 2013 and currencies of major emerging market countries declined by up to 15 percent.[vi] These pressures stabilized somewhat before currency volatility again resumed in December when the Fed announced it would begin slowly begin unwinding its QE program.
Figure 2: 'Fragile Five' Currency Depreciation
Not all emerging market countries have been equally affected by these financial market pressures. In fact, World Bank data shows that two-thirds of developing countries saw their currencies remain stable or appreciate during this time.[vii] The countries affected were mostly large middle-income economies such as Brazil, Turkey, Indonesia and India which have relatively deep and liquid financial markets that allowed investors to quickly divert their funds. However, macroeconomic fundamentals played a part too. Countries like Mexico and Chile which received large inflows during the QE period were less affected by the adjustment in investor portfolios. This resilience has been linked this to careful macroeconomic policies such as prudent fiscal management, a competitive export sector, and regulatory reform.
In conclusion, a three pronged approach is called for in order to minimize the financial and economic instability caused by the Fed’s winding down of its quantitative easing program. First, emerging market policymakers must realize that Rodrik and Subramaniam are right—financial globalization is not for everyone. Well-functioning capital markets translate savings into productive investment, allowing for greater and faster economic diversification. Developing such markets will often require greater integration with international capital flows. However, greater integration requires prudent macroeconomic policymaking capacity and the temerity to withstand temporary shocks. This would automatically preclude many smaller and less developed emerging market countries. Larger countries such as India and Indonesia must bring their fiscal deficits under control through targeted measures such as cutting back on wasteful food and fuel subsidies and transitioning to a more efficient social safety net based on cash transfers.
Second, greater coordination among the countries of the G-20 is required to ensure that the still feeble global economic recovery is not stifled by a double whammy of contractionary monetary and fiscal policies at the same time. Part of the blame for the slow recovery from the crisis has to be assigned to policy choices made in developed countries which were too quick to move from stimulus to austerity. While most emerging market countries have exhausted their capacity to engage in counter-cyclical policy responses, there is still room to do more in developed countries. At the very least, current levels of government spending ought not to be curtailed in the short to medium run.
Third, and finally, both developing and developed countries must do more to dismantle global trade barriers. The recent progress on reaching an agreement on trade facilitation as part of the Doha Round of trade talks is an important first step but more remains to be done, particularly with respect to the thorny issue of agricultural subsidies.
Put together these measures have the potential of ensuring that global economic growth is strong enough to withstand the financial volatility that come to the end of the post-crisis age of extraordinary monetary policy.
Eichengreen, B., & Gupta, P. (2013). Fed tapering and emerging markets. Vox. Retrieved February 17, 2014, from http://www.voxeu.org/article/fed-tapering-and-emerging-markets
Krugman, P. (2014, January 30). Talking Troubled Turkey. The New York Times. Retrieved from http://www.nytimes.com/2014/01/31/opinion/krugman-talking-troubled-turke...
Rodrik, D., & Subramaniam, A. (2014). Emerging Markets’ Victimhood Narrative. Bloomberg. Retrieved February 17, 2014, from http://www.bloomberg.com/news/2014-01-31/emerging-markets-victimhood-nar...
The World Bank. (2014). Coping with policy normalization in high-income countries. Washington DC. Retrieved from http://www.worldbank.org/en/publication/global-economic-prospects
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