Tailspin or Turbulence?

WASHINGTON, DC – Since the beginning of the year, a new wave of doubt has engulfed emerging markets, driving down their asset prices. The initial wave struck in the spring of 2013, following the Federal Reserve’s announcement that it would begin tapering its monthly purchases of long-term assets, better known as quantitative easing (QE). Now that , the emerging-market bears are ascendant once again.

Pressure has been strongest on the so-called Fragile Five: Brazil, India, Indonesia, South Africa, and Turkey (not counting Argentina, where January’s mini-crisis started). But worries have extended to other emerging economies, too. Will the Fed’s gradual reduction of QE bring with it more emerging-market problems this year? To what extent are today’s conditions comparable to those that triggered the Asian crisis of 1997 or other abrupt capital-flow reversals in recent decades?

Emerging-market bulls point out that most major middle-income countries have substantially lowered their public debt/GDP ratios, giving them fiscal space that they lacked in the past. But neither the Mexican Tequila crisis of 1994 nor the Asian crisis of 1997 was caused by large public deficits. In both cases, the effort to defend a fixed exchange rate in the face of capital-flow reversals was a major factor, as was true in Turkey in the year prior to its currency collapse in February 2001.

Today, most emerging countries not only have low public-debt burdens, but also seem committed to flexible exchange rates, and appear to have well-capitalized banks, regulated to limit foreign-exchange exposure. Why, then, has there been so much vulnerability?

To be sure, the weakest-looking emerging countries have large current-account deficits and low net central-bank reserves after deducting short-term debt from gross reserves. But one could argue that if there is a capital-flow reversal, the exchange rate would depreciate, causing exports of goods and services to increase and imports to decline; the resulting current-account adjustment would quickly reduce the need for capital inflows. Given fiscal space and solid banks, a new equilibrium would quickly be established.

Unfortunately, the real vulnerability of some countries is rooted in private-sector balance sheets, with high leverage accumulating in both the household sector and among non-financial firms. Moreover, in many cases, the corporate sector, having grown accustomed to taking advantage of cheap funds from abroad to finance domestic activities, has significant foreign-currency exposure.

Where that is the case, steep currency depreciation would bring with it serious balance-sheet problems, which, if large enough, would undermine the banking sector, despite strong capital cushions. Banking-sector problems would, in turn, require state intervention, causing the public-debt burden to rise. In an extreme case, a Spanish scenario could unfold (though without the constraint of a fixed exchange rate, as in the eurozone).