by Julius Probst
One stylized economic history fact is that emerging markets are much more prone to financial and currency crises than advanced economies. Since the end of Bretton Woods in 1971, emerging economies have experienced a large number of crises. Here are just a few examples: Mexico’s Tequila Crisis in 1994, the financial crisis that spread throughout Southeast Asia in 1997, and the Russian default in 1998. For a more detailed overview, you can consult Reinhart and Rogoff‘s “This time is different” and Krugman’s “Depression Economics”, for example.
The problems in emerging market economies are manifold, but there are two things that stand out, in particular. First, the quality of institutions is significantly lower compared to advanced economies, thus making these economies much more vulnerable to a variety of internal and external shocks. While the methodology of such rankings can always be questioned, the difference in scores between high- and low- income countries is striking.
Second, emerging markets often engage in what in macroeconomics is sometimes called the original sin, i.e. they borrow excessively in foreign currency, usually USD. Borrowing in foreign currency is obviously more dangerous because of the added exchange rate risk. The canonical model of the currency crisis started with Krugman (1979), which tied such crises to worsening macroeconomic fundamentals. More specifically, a country with a pegged exchange rate but excessive fiscal deficits would eventually run into trouble, because it only has a limited amount of foreign exchange reserves. These reserves can get depleted very quickly once a speculative attack on the currency takes place, thus forcing the country to abandon the pegged exchange rate agreement.
The more recent literature on currency crises has also elaborated on the role of contagion between countries, emphasizing the importance of multiple equilibria in macroeconomics. As Krugman (1999) acknowledged, the events of the Asian Crisis and also the more recent Eurozone Crisis cannot be understood without having a macroeconomic framework in mind that allows for expectations to affect the underlying fundamentals, i.e. self-fulfilling prophecies. Especially during the Asian Crisis, one could see how framing matters as foreign investors tend to bundle countries together. While the crisis originated in South East Asia, it rapidly spread to other countries in the broader region. Even Korea, with solid fundamentals, was affected as investors withdrew funds at a rapid pace. Korea’s economic situation therefore deteriorated quickly as a result of portfolio outflows that were at first unrelated to the initial economic situation. The newer generation models of currency crises like Obstfeld (1995) and Krugman (1999), therefore allowed for exactly this kind of dynamic to play out.
While the current downturn is truly unprecedented in advanced economies, emerging markets are facing an even more dire situation that can easily turn into the mother of all currency crises, if the global economic environment continues to deteriorate.
Commodity prices have been crashing as a result of the global Covid-19 shock, dragging down emerging market currencies with them. The spectacular fall in oil prices since the beginning of this year is particularly remarkable. While this will mean higher disposable income for consumers in advanced economies, there is good reason to believe that it is a net negative for the global economy right now. First, it is quite likely that cash-constrained consumers will simply save most of the windfall gain coming from lower oil prices. Second, the decline is obviously very bad news for oil producers, including the US and Canada, as the fracking industry cannot remain competitive below a price of about 40-50 USD. While the sector is very capital-intensive, initial employment losses will therefore be limited, the price decline will have a severe negative impact on business investment with potentially big knock-on effects. Therefore, I don’t think one should expect low oil prices to provide an economic boost right now; it’s rather a sign of a severe global economic glut.
One additional point of worry is that some emerging markets already had weakening fundamentals before the crisis. In fact, I pointed out a while ago that current account deficits in several emerging markets are a concern. And as our charts below show, countries like Mexico and South Africa, which should grow relatively faster given their current GDP per capita levels, entered this current crisis with negative growth momentum.
Consequently, EMs and commodity exporters will be the most vulnerable in today‘s global macroeconomic environment. Not only will the decline in commodity prices lead to a severe compression of incomes, but EMs are also experiencing record capital ouflows. Furthermore, these countries have significantly less fiscal space than advanced economies, and as a result of the current unprecedented downturn, debt markets are becoming increasingly distressed. CDS on governments securities have surged rapidly, meaning that it has become more costly to insure yourself against EM debt defaults, a sure sign that these countries are facing hard budget constraints right now.
In terms of current account imbalances, we should rather view them as the difference between savings and investments. Remember that GDP is equal to consumption plus investment, government expenditure and net exports.
Y = C + I + G + NX
And savings is simply income not consumed:
S = Y – C – G
Rearranging, one can obtain that the difference between domestic savings and investment is therefore simply net exports, the current account:
CA = NX = S – I
One of the dirty secrets in international macroeconomics is that the CA balance is actually not determined by trade flows, but rather international savings and investment decisions, and the associated capital flows that result from them. Whenever a country runs a CA surplus, it is building up its stock of net external assets and accumulating claims vis-à-vis the rest of the world, while deficit countries are increasing their net liabilities.
A deficit or surplus is never good or bad in itself. Countries like the US or Australia have run deficits for many decades without a problem. However, especially in the case of the US, this is due to its unique and exorbitant privilege of being the issuer of the global reserve currency.
In the case of EMs, however, excessive and persistent deficits are usually a sign of trouble. As the chart below shows, the accumulated total current account deficit for several EMs has been approaching or even exceeding some 30% of GDP over the last decade, meaning that their net external liabilities have significantly increased over time.
Right now, as these capital flows are reversing at an unprecedented speed, EMs will have to quickly adjust in the face of a sudden stop of net inflows (Calvo et al., 2004).
Simple mechanics suggest that such a Balance of Payments adjustment can only happen via a strong decline in imports that brings the current account back into balance, which would also imply a significant compression of domestic demand.
The reversal of “hot money” – short-term capital flows that are usually portfolio investments (instead of long-term investment decisions like foreign direct investments which are tangible and therefore not as quickly reversable) – are at the origin of many of the EM crises we have seen over time.
Currency mismatch, a common phenomenon across emerging markets, is one of the key determinants of the subsequent crisis. Borrowing in foreign currency, typically USD, while your income and assets are denominated in domestic currency, leads to severe balance sheet problems as the crisis hits and your own currency starts to devalue, with obvious negative effects on aggregate demand.
While, in the past, many economists have focused on net capital flows, the more recent literature has moved beyond that (Forbes and Warnock, 2012). In today’s world of financial globalization, gross financial positions have become a large multiple of domestic GDP in many countries. Simply looking at net flows might therefore not do justice to the underlying dynamics and balance sheet risks that are associated with increasingly large gross positions.
While many emerging markets are actually not as financialized as most advanced economies, the trend towards increasingly large gross external debt positions is quite clear. In the picture below, it is not so much the level as the first derivative (the rate of change) that seems to be problematic for EM economies in terms of risk management.
From a capital flow perspective, a sudden stop in net inflows can either be driven by a stop in gross capital inflows or a surge in gross capital outflows, or both. Focusing on gross flows therefore also allows you to distinguish between the behavior of residents vs. foreign investors during a capital flow crisis, which is the approach that a lot of the recent macroeconomic contributions have taken.
From a surveillance perspective, policy makers find themselves once again in a tough spot. Data from the IIF suggests that EM capital outflows have surged to levels never seen before, some 80 billion USD or more in recent weeks, much larger in size than the one that occurred during the financial crisis of 2008 or the famous ”Taper Tantrum” in 2013. The big problem is that these capital movements can happen within days, while policy makers do not even have the tools to observe what is going on real time.
While spending some time doing a research project on this very same topic at the ECB last year, I had to make the painful observation that a lot of the macro data on capital flows is of rather poor quality, especially when it comes to emerging markets. Furthermore, similarly to other macro data, the frequency is simply too low to pick up on rapidly emerging huge macroeconomic crises like the one we are facing currently. As a side note, just this week, we actually added a new indicator by the NY Fed to the Macrobond database that addresses this problem. It estimates real economic activity on a weekly basis – more on this in a future blog post.
It is only more recently that economists have started to guesstimate the extent to which trillions of dollars are funneled through rather dodgy tax havens via shell corporations and other corporate entities, very often for the purpose of tax avoidance. As many portfolio flows are channeled through places like the Cayman Islands, for example, it is extremely difficult for policy makers and regulators to understand both the origin as well as the ultimate destination of those flows.
What is abundantly clear, though, is that EMs are currently experiencing record portfolio outflows in real time, as the chart below illustrates. Both equity and bond market outflows are approaching or even exceeding those at the peak of the Financial Crisis in 2008.
On top of this, the global economy is also experiencing a steep decline in world trade as a result of the Covid-19 shock. The RWI container throughput index shows that global container trade is already some 10% below trend as of February 2020. And remember that this is before the big economic shutdown that advanced economies have imposed throughout March. We will therefore see an unprecedented stop in global trade even worse than during the Great Recession, which will just aggravate current EM troubles.
Macrobond Moment: It is super easy to calculate deviations from a trend in the Macrobond platform with just one click using our DETREND analysis. I have also applied our seasonal adjustment analysis using the SEATS method.
I therefore believe that Adam Tooze is unfortunately right when he suggests that EMs are facing the most severe crisis they have ever faced. On top of the capital sudden stop, which will soon cause a wave of currency crises, these countries are also suffering from a collapse of global trade. Finally, many simply do not have sufficient fiscal space to combat the downturn. While rich countries can currently borrow at record negative interest rates as investors flock into save haven assets, risk premiums on EM debt have already soared. All three of these factors taken together suggest that EMs are in for a crisis, and that it will be a big one.
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