Turbulence in emerging economies:
From easy money to hard landing?
Before the world economy could fully recover from the crisis that
began more than five years ago, there is a widespread fear that we may
be poised for yet another crisis, this time in emerging economies (EEs).
Once again, most specialists on international economic matters have
been caught unawares. In fact, the signs of external financial fragility
in several emerging economies have been visible since the beginning of
the financial crisis in the US and Europe.
The South Centre has constantly warned that the boom in capital flows
that had started in the first half of the 2000s and continued even after
the Lehman collapse is generating serious imbalances in the developing
world along with the danger of a sudden stop and reversal.
Policy choices in advanced economies, notably in the US as the issuer
of the main reserve currency, in response to the crisis are key to
understanding what is going on.
Reluctance to remove the debt overhang caused by the financial crisis
through timely, orderly and comprehensive restructuring, and an abrupt
turn to fiscal austerity after an initial expansion, has meant an
excessive reliance on monetary means to fight the Great Recession, with
Central Banks entering unchartered policy waters, including zero-bound
policy interest rates and the acquisition of long-term public and
private bonds (quantitative easing).
This ultra-easy monetary policy has not been very effective in
reducing the debt overhang or stimulating spending. It has, however,
generated financial fragility, notably in emerging economies.
Monetary tightening
The US itself is vulnerable because the Fed (Federal Reserve) may not
exit from the ultra-easy monetary policy and normalise the size and
structure of its balance sheet without market disruption and it cannot
continue without creating bubbles.
Tapering does not yet signal a return to monetary tightening and
normalisation of the Fed's balance sheet.
It does not reduce the level of long-term assets on the Fed's balance
sheet but only monthly additions. Besides, the policy rates are pledged
to remain at historical lows for some time to come, even after the
unemployment rate falls below 6.5%, if inflation remains low. Thus,
ultra-easy money is still with us.
But the markets have already started pricing-in the normalisation of
monetary policy and this is the main reason for the rise in long-term
rates and the turbulence in emerging economies.
In several emerging economies, policies pursued in recent years have
no doubt made a significant contribution to the build-up of external
vulnerability.
Many commodity-dependent economies have failed to manage the twin
booms in commodity prices and capital flows that started in the early
years of the millennium and continued until recently, after a brief
interruption in 2008-09.
These countries, and several others, have stood passively by as their
industries have been undermined by the foreign exchange bonanza,
choosing, instead, to ride a consumption boom driven by short-term
financial inflows and foreign borrowing by their private sectors and
allowing their currencies to appreciate and external deficits to mount.
Hastily erected walls against destabilising inflows have been too
little too late - and neither wide enough nor high enough to prevent
build-up of imbalances and fragility.
Emerging economies
The IMF, the organisation responsible for safeguarding international
monetary and financial stability, has also failed to promote judicious
policies not only in major advanced economies, but also in the South.
It has been unable to correctly identify the forces driving expansion
in emerging economics and joined, until its recent u-turns, the hype
about the 'Rise of the South', arguing that major emerging economies are
largely decoupled from the economic vagaries of the North and have
become new engines of growth, thereby underestimating their
vulnerability to shifts in policies and conditions in the North, notably
the US.
Even when it became clear that capital inflows posed a serious threat
to macroeconomic and financial stability in these economies, its advice
was to avoid capital controls to the extent possible and introduce them
only as a last resort and on a temporary basis.
Policy response to a deepening of the financial turbulence in the
South and tightened balance of payments should be similar in many
respects to that recommended by the South Centre in the early days of
the Great Recession. The principal objective should be to safeguard
income and employment.
Developing countries should not be denied the right to use legitimate
trade measures to rationalise imports through selective restrictions to
allocate scarce foreign exchange to areas most needed, particularly for
the import of intermediate and investment goods and food.
Emerging economies should also avoid using their reserves to finance
large and persistent capital outflows. Experience suggests that when
global financial conditions are tightening, countries with large
external debt and deficits find it extremely difficult to restore
'confidence' and regain macroeconomic control simply by allowing their
currencies to freely float or hiking interest rates.
Nor should they rely on borrowing from official sources to maintain
an open capital account and to remain current on their obligations to
foreign creditors and investors.
Liquidity
They should, instead, seek to involve private lenders and investors
in the resolution of balance of payments and debt crises and this may
call for, inter alia, exchange restrictions and temporary debt
standstills. These measures should be supported by the IMF, where
necessary, through lending into arrears.
The IMF currently lacks the resources to effectively address any
sharp contraction in international liquidity resulting from a shift to
monetary tightening in the US.
A very large SDR (Special Drawing Rights) allocation, to be made
available to countries according to needs rather than quotas, would
help.
But a greater responsibility falls on Central Banks in advanced
economies, notably the US Fed, which can and should - as the originators
of destabilising impulses that now threaten the South - act as a
quasi-international lender of last resort to emerging economies facing
severe liquidity problems through swaps or outright purchase of their
sovereign bonds.
The Fed could buy internationally issued bonds of these economies to
shore up their prices and local bonds to provide liquidity; and there is
no reason why other major Central Banks should not join this
undertaking. The extent to which these tools - exchange restrictions and
temporary debt standstills, IMF lending into arrears, a sizeable SDR
allocation and provision of market support and liquidity by major
Central Banks - should be used would no doubt depend on the specific
circumstances of individual EEs.
- Third World Network Features
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