The taper wolf at the door

SANTIAGO, Chile - Last spring, U.S. Federal Reserve Board Chairman Ben Bernanke made a small announcement that had big consequences. The mere possibility that the Fed might reduce its purchases of long-term assets - the so-called taper - sent market interest rates in the United States soaring and currencies in countries like Brazil, Turkey and India plummeting.

Unexpected backtracking by the Fed in September gave markets a reprieve. But now investors are again asking what will happen in emerging markets if and when the big bad taper wolf shows up.

As always with economists, there are two schools of thought. Optimists claim that most emerging economies are well prepared to withstand the shock, because their dollar debts are lower than in the past, while their fiscal positions are much stronger. Pessimists claim that in the absence of well-developed local financial markets and a global lender of last resort, emerging economies remain vulnerable to a sudden stop in capital flows.

There is merit to both views, but one must dig a little deeper to see why. To say that emerging markets’ financial and fiscal positions are stronger raises the economist’s traditional question: Compared to what?

If the base of comparison is the eve of the 1997-98 Asian financial crisis (which later spread as far as Moscow and Buenos Aires), it is clear that, in most countries, vulnerabilities have lessened. Countries like Colombia, Mexico and South Africa have managed to issue international debt in their own currencies, partly overcoming the burden of what some economists had called “original sin” - that is, an environment in which most countries must issue debt denominated in, say, dollars.

Other countries like Brazil have extended the maturity profile of their public debt, and are therefore less vulnerable to rollover risk. And commodity producers have indeed been more fiscally prudent over the last decade than they were during earlier commodity booms.

But if the base of comparison is 2007, just before the global financial crisis, a somewhat different picture emerges. The much-needed counter-cyclical fiscal packages of 2009 overstayed their welcome in several countries, resulting in larger public-debt burdens. And the substantial capital inflows since 2010 have caused sharp asset-price increases and swift credit expansion in countries ranging from Chile to Malaysia. So what could happen when those flows are reversed?

To answer that question, one needs to assess the plausible channels through which an external financial shock is transmitted to an emerging economy. In my view, there are three important transmission mechanisms.

The first is the exchange rate - more precisely, a fall in the currency’s inflation-adjusted value. In developed countries with floating exchange rates, a drop in foreign lending can be expansionary if currency depreciation stimulates exports. But in emerging economies with substantial dollar debts - whether private or public - devaluation raises the cost of outstanding debt (when measured in domestic currency) and can wreak havoc with balance sheets and creditworthiness.

While emerging markets have reduced their dollar debts, they have not done so sufficiently to reassure markets. During the May-June quasi-panic that followed Bernanke’s statement, it was countries with large external deficits (making them the most obvious candidates for real depreciation) - for example, India, South Africa, and Turkey - that suffered the sharpest sell-offs.

The second plausible transmission mechanism is asset prices. For example, capital inflows have boosted demand for local land and driven up its price. Land holdings can, in turn, be used as collateral, stimulating further credit flows and triggering successive rounds of asset-price appreciation.

When capital flows stop, this entire process unwinds, inflicting much pain. The drop in the price of land (and of other assets) impairs their role as collateral, causing domestic credit flows to suffer. Companies - especially smaller ones - that cannot even get working capital are sure to cut back on employment and investment.

Hong Kong, Singapore, Brazil and China are four countries where land and real estate prices have risen sharply in recent years. How much will those economies suffer when the music stops?

The third transmission channel is public debt. The direct impact is obvious: A government that cannot borrow will have to cut spending or raise taxes, with contractionary consequences. But the indirect impact can be nastier. If a well-functioning government-debt market is needed to ensure financial stability in developed countries, it is even more important in emerging countries. Banks, for example, hold large stocks of government bonds. A sharp drop in those bonds’ value will surely affect banks’ ability to lend to the private sector.

All of these mechanisms have one thing in common: They operate through financial markets and can cause a credit crunch. Such crunches, history shows, are an omnipresent feature of the aftermath of sudden stops in capital flows. And when credit is scarce, recoveries are inevitably slow.

Of course, all such worries would be dispelled if the International Monetary Fund or some other entity would serve as a fast and effective global lender of last resort. But that will not happen for many years to come. In the meantime, several emerging economies will remain places from which you wish you could emerge in an emergency.

Copyright: Project Syndicate, 2013.

*The author, a former finance minister of Chile, is a visiting professor at Columbia University.

by Andres Velasco