Global Trends by Martin Khor

Monday 9 September 2013

Turmoil in emerging economies

The G20 Summit last week discussed a new phenomenon – economic turmoil beginning in some major developing countries. Coordination to prevent future crises is still elusive.


What a difference half a year makes.   At the G20 Summit last week, attention turned to the weakening of the emerging economies.

This was a contrast to previous summits.  Then, the major developing countries were seen as the drivers of global growth, as the developed countries’ economies were faltering.

For two years or so, the European crisis was the focus of anxiety.  The American economy was also plagued with domestic problems.  The economies of the developing world, including China, India, Brazil and Indonesia and other Asean countries, were the safety net keeping the global economy afloat. 

But in its report for the G20 summit in St. Petersburg, the IMF had to do an embarrassing about-turn.  It reversed its previous theory that the emerging economies were on the fast-track and keeping the global growth going.  It now warned that the stagnation in these countries is now a drag on the global economy.

Developing countries’ leaders correctly point out that their economies have been victims to the developed countries’ monetary policies, especially the United States’ “quantitative easing” (QE), under which the Federal Reserve has been pumping US$85 billion a month into its banking system.

A lot of this ended up in developing countries’ equity and bond markets, as US investors searched for higher yields there, since the US interest rates have been kept near zero.

However, when the Fed chairman indicated the QE would be “tapering off” and long-term interest rates started rising in response, the capital invested in developing countries has been flowing back to the US.

Vulnerable emerging economies have been hard hit, and worse may yet come.  Especially vulnerable are those which have a current account deficit, since they depend on capital inflows to fund these deficits.

The outflow of needed capital and the increased risk have caused their currencies and their stock markets to plunge.  This in turn leads to more capital outflow, due to anticipation of further falls in equity prices and in the domestic currency itself. The currency depreciation also fuels inflation.

Thus, former stalwarts India, Indonesia, Brazil, South Africa, Turkey are now the victims of a vicious circle.

In Indonesia, the currency fell last week across the 11,000 rupiah to the dollar mark (it was 9,500 a year ago), as the July monthly trade deficit rose to US$2.3 billion and the annual inflation rate hit 8.8% in August.

In India, the currency fell to 68 rupee to the dollar (from 56 a year ago) before recovering to 65 rupee after a well-received inaugural media conference by the new Central Bank Governor last Thursday.

India’s current account balance is running at around US$90 billion a year, making it very dependent on capital inflows. 

In mid-August, the government introduced limited capital control measures including restricting citizens’ money outflows to US$75,000 a person (from US$200,000 previously) and restraining local companies’ investments abroad.    

The current account deficits are also significant in South Africa ($25 billion in latest 12 months), Brazil ($78 billion) and Turkey ($$54 billion), making them vulnerable to the vagaries of capital flows.

The South African rand has fallen in value by 18%.  President Jacob Zuma blamed the currency slide on the potential tapering of the US quantitative easing.

“Decisions taken countries based solely on their own national interest can have serious implications for other countries,” he justifiably complained.

Malaysia’s currency value has also dropped recently, but the country is not as vulnerable as it has been running a current account surplus (US$14.2 billion in the 12 months to June).

However, the trade surplus has not been as strong recently and there is always a danger of “contagion effect”, which we know is often not based on rationality.

Countries affected have a few policy tools to deal with the situation.  One is to try to stabilise the currency through the Central Bank purchasing the local currency by selling the US dollar. 

But this is expensive, and the country may draw down its reserves, especially if speculators keep betting that its currency will fall by more.  This is the bitter lesson that Thailand and others learnt in the 1997 financial crisis. 

Another policy measure is capital controls. Ideally this should be imposed to prevent inflows. 

But most countries allow the inflows in the good times, and then when these suddenly turn into outflows, the boom-bust problem if laid bare.

Malaysia in 1998-99 imposed controls on outflows of both residents and foreigners, which was effective in stopping the crisis.  It was heavily criticised at that time, but now even the International Monetary Fund is recommending capital controls if the situation is bad enough.

Ultimately there has to be international reforms to prevent excessive capital flows from the source countries, and developed countries have to be disciplined so that their economic policies do not have negative fallout effects on developing countries.

But we will have to wait for such useful international coordination on capital flows and economic policies to take place.