Tuesday, January 28, 2014

Emerging Markets: No, It Isn’t 1997 Again

It seems to be my day to get beaten to the gun. I was going to write a post on this issue, but Lars got there first (excerpt):

Please don’t fight it – the risk of EM policy mistakes

Emerging Markets are once again back in the headlines in the global financial media – from Turkey to Argentina market volatility has spiked from the beginning of the year….

…Lets take the case of Turkey and lets assume Turkey is operating a pegged exchange rate regime – for example against the US dollar. And lets at the same time note that Turkey presently has a current account deficit of around 7% of GDP. This current account deficit is nearly fully funded by portfolio inflows from abroad – for example foreign investors buying Turkish bonds and equities.

As long as investors are willing to buy these assets there is no problem. But then one day investors decide to close down their positions in Turkey…Lets assume this leads to a “sudden stop”. From day-to-day the funding of Turkey’s 7% current account deficit disappears.

Now Turkey has a serious funding problem...the current account deficit needs to be closed. That can happen either by a collapse in imports and/or through spike in exports.

To “force” this process the central bank will have to tighten monetary conditions dramatically. This happens “automatically” in a fixed exchange rate regime…The result is a collapse in private consumption, investments, asset prices and increased deflationary pressures (inflation and wage growth drop). An internal devaluation will be underway. The result is normally a sharp increase in public and private debt ratios as nominal GDP collapses….This would cause a massive collapse in economic activity and as asset prices and growth expectations drop financial distress also increases dramatically, which could set-off a financial crisis.

This is the kind of scenario that played out during the Asian crisis in 1997, but it is also what happened in Turkey in 2001 and forced the Turkish government to eventually give up a failed pegged (crawling) peg regime.

I really couldn’t have put it any better, though I would have used Malaysia and Indonesia as examples.

Short version: don’t worry about the Ringgit depreciating – that’s the precise thing that’s going to save us from another 1997-style financial crisis. Don’t worry about the KLCI coming down – it’s not a foreign investor referendum on Malaysia. Don’t worry about market interest rates rising – they’ve been at historical lows for long enough, it’s time to get back to “normal”.

Not everything is hunky-dory – there’s still some contagion risk, and structural issues remain for Malaysia – but I don’t see a financial market collapse on the horizon any time soon. The banking system still has a positive net foreign asset position, and this is further backed up by Bank Negara’s international reserves (which remain untouched), and even further backed by the multilateral and bilateral FX swap agreements BNM has made with other regional central banks.

Touch wood, the lessons of the past have been learned, and we won’t be repeating the same disastrous policy mistakes.


  1. Love your commentaries, always.

  2. http://www.telegraph.co.uk/finance/financialcrisis/10618015/Emerging-markets-more-vulnerable-than-ever-to-Fed-tightening-warns-BIS.html

    Your comment on this would be great thanks!

    1. @anon

      It's not far off the mark. Just recognise that not every country is the same, and some are much more vulnerable than others.

      But the point about corporate debt is spot on - it's not government debt that will be the main problem. If there is a point of vulnerability in Malaysia, it will be in corporate debt. However, even here, our debt market is deep enough and liquid enough that most corporate issuance is local and in Ringgit. Those companies that have issued globally (*cough* 1MDB *cough*) would on the other hand be highly vulnerable.