Tailspin or Turbulence?

It is this danger that sets a practical and political limit to flexible exchange rates. Some depreciation can be managed by most of the deficit countries; but a vicious circle could be triggered if the domestic currency loses too much value too quickly. Private-sector balance-sheet problems would weaken the financial sector, and the resulting pressure on public finances would compel austerity, thereby constraining consumer demand – and causing further damage to firms’ balance sheets.

To prevent such a crisis, therefore, the exchange rate has to be managed – and in a manner that depends on a country’s specific circumstances. Large net central-bank reserves can help ease the process. Otherwise, a significant rise in interest rates must be used to retain short-term capital and allow more gradual real-sector adjustment. Higher interest rates will of course lead to slower growth and lower employment, but such costs are likely to be smaller than those of a full-blown crisis.

The challenge is more difficult for countries with very large current-account deficits. And it becomes harder still if political turmoil or tension is thrown into the mix, as has been the case recently in a surprisingly large number of countries.

Nonetheless, despite serious dangers for a few countries, an overall emerging-market crisis is unlikely in 2014. Actual capital-flow reversals have been very limited, and no advanced country will raise interest rates sharply; in fact, with the , net flows from the US have increased over the last 12 months.

Moreover, most emerging-market countries have strong enough fiscal positions and can afford flexible enough exchange rates to manage a non-disruptive adjustment to moderately higher global interest rates. Much of the recent turmoil reflects the growing realization that financial-asset prices worldwide have been inflated by extraordinarily expansionary monetary policies. As a result, many financial assets have become vulnerable to even minor shifts in sentiment, and this will continue until real interest rates approach more normal long-run levels.

In the medium term, however, the potential for technological catch-up growth and secular convergence remains strong in most emerging countries. The pace of a country’s convergence will depend, even more than in the past, on the quality of governance and the pace of structural reforms.

Kemal Derviº, former Minister of Economic Affairs of Turkey and former Administrator for the United Nations Development Program (UNDP), is Vice President of the Brookings Institution.

Copyright: Project Syndicate, 2014.