Global Trends by Martin Khor

Monday 27 January 2014

Emerging Economies Facing New Crisis?

The two-day sell off of currencies and shares of several developing countries last week raises the question whether this is the start of a new financial crisis. 


At the end of last week, several developing countries experienced sharp falls in their currency as well as stock market values, prompting the question whether it is the start of a wider economic crisis.

The sell-off in emerging economies also spilled over to the American and European stock markets, thus causing global turmoil.

Countries whose currencies were affected included Argentina (whose peso fell 16% after the Central Bank stopped supporting it), Turkey, Russia, Brazil and Chile. 

Malaysia was not among the most badly affected, but the ringgit also declined in line with the trend by 1.1% against the US dollar last week; it has fallen 1.7% so far this year.  

An America market analyst termed it an “emerging market flu” and several global media reports tend to focus on weaknesses in individual developing countries.

However the across-the-board sell off is a general response to the “tapering” of purchase of bonds by the US Federal Reserve, which marks the slowdown of its easy-money policy that has been pumping many hundreds of billions of dollars into the banking system. 

A lot of that was moved by investors into the emerging economies in search of higher yield.  Now that the party is over (or at least winding down), the massive inflows of funds is slowing or even stopping in some developing countries.


The current “emerging markets sell-off” is thus not explained by ad hoc events.  It is a predictable and even inevitable part of a boom-bust cycle in capital flows to and from the developing countries, which originates from the monetary policies of developed countries and the investment behaviour of their investment funds.

This cycle, which has been very destabilising to the developing economies, has been facilitated by the deregulation of financial markets and the liberalisation of capital flows which in the past had been carefully regulated.

This prompted massive and increasing bouts of speculative international flows by investment funds, motivated by the search for higher yields. Emerging economies, having higher economic growth and interest rates, attracted the investors.

Yilmaz Akyuz, chief economist at South Centre, analysed the most recent boom-bust cycles in his paper “Waving or Drowning?”

A boom of private capital flows to developing countries began in the early years of the 2000s  but came to an end with the flight to safety triggered by the Lehman collapse in September 2008.

However, the flows recovered quickly. By 2010-12, net flows to Asia and Latin America exceeded the peaks reached before the crisis.

This recovery was largely caused by the easy-money policies and near zero interest rates in the US and Europe.

In the US, the Fed pumped US$85 billion a month into the banking system by buying bonds.  It was hoped the banks would lend this to businesses to generate recovery, but in fact investors placed much of the funds in the stock markets and developing countries.

The surge in capital inflows led to a strong recovery in currency, equity and bond markets of major developing countries.  Some of these countries welcomed the new capital inflows and the boom in asset prices.

But others were angry that the inflows caused their currencies to appreciate (thus making their exports less competitive) and that the ultra-easy monetary policies of developed countries were part of a “currency war” to make the latter more competitive.

In 2013, the capital inflows into developing countries weakened due to the European crisis and the prospect of the US Fed “tapering” or reducing its monthly bond purchases.

This weakening took place at a bad time – just as many of the emerging economies saw their current account deficits widen.  Thus, their need for foreign capital increased just as inflows became weaker and unstable.

In May-June 2013 there was a preview of the current sell-off when the Fed announced it could soon start “tapering”.  This led to sudden sharp currency falls including in India and Indonesia.

However, the Fed postponed the taper, thus giving a breathing space.  But in December, it finally announced the tapering – a reduction of its monthly bond purchase from $85 billion to $75 billion, with more to come.  

There was then no sudden sell off in emerging economies, as the markets had already anticipated it and the Fed also announced that interest rates would be kept at current low levels until the end of 2015.

By now, however, the investment mood had already turned against the emerging economies.  Many of them were now termed “fragile”, especially those with current account deficits and dependent on capital inflows.

Most of the so-called Fragile Five are in fact members of the BRICS that had been viewed just a few years before as the most influential global growth drivers.  


In this atmosphere of deepening concerns, it just required a “trigger” to cause a simultaneous sell-off in currencies and markets of developing countries.

Several factors were to emerge last week which together constituted a trigger.  These were a “flash” report indicating contraction of manufacturing in China; the sudden fall in the Argentinian peso; and expectations that a US Fed meeting on 29 January will announce another instalment of tapering.

For two days (23 and 24 January) the currencies and stock markets of several developing countries were in turmoil, which spilled over to the US and European stock markets.

If this situation continues this week, it could signal a new phase of investor disenchantment with emerging economies, with reduced capital inflows or even outflows.  This could put strains on the affected countries’ foreign reserves and weaken their balance of payments.

The accompanying fall in currency would have positive effects on export competitiveness, but negative impacts in accelerating inflation (as import prices go up) and debt servicing (as more local currency is needed to repay the same amount of debt denominated in foreign currency).

This week will thus be critical in seeing whether the emerging economy situation deteriorates or whether it stabilises, which may just happen if the Fed decides to discontinue its tapering for the time being.  Unfortunately, the former situation is more likely.