In past decades, emerging markets were traditionally thought of as “basket case” economies, with the associated stigma.
Perceptions have improved in recent years, but there are still concerns these economies may once again fall down the slippery crisis-ridden path, driven by tapering in quantitative easing that has begun in the US, and political unrest.
Why is it that some news, like the devaluation of a currency or announcement of fiscal problems, trigger a rapid adverse contagious chain reaction among emerging economies?
The sell-off of the Thai baht on July 2, 1997 for example, triggered financial turmoil right across East Asia with countries like Indonesia, Korea, Malaysia, and the Philippines being the hardest hit.
Similarly, when Russia defaulted on its sovereign bonds on August 18, 1998, the effects were felt internationally in other markets like Hong Kong, Brazil, Mexico and many other emerging markets.
The ensuing cascade of economic effects from these shocks typically include major declines in share prices, free-falls in the value of the currency (and/or escalating price levels), hikes in the cost of borrowing, severely reduced access to international capital, rising unemployment and a decline in capital investments, output and economic growth. It takes many years for affected emerging economies to bounce back from these economically and socially disruptive episodes.
Research has highlighted three main reasons emerging markets are prone to experiencing fast and furious declines when there is an adverse economic shock. These crisis periods are typically characterised by “the unholy trinity”: (i) they follow a large surge in capital flows; (ii) the shock comes as a surprise to market participants; and (iii) they involve leveraged common creditors forced to withdraw from multiple countries at once.
Emerging markets are prone to “hot money flows”. In stable times, international investors will chase higher yields in emerging market economies. But with better returns comes more risk, so the same investors and creditors are highly sensitive and tend to panic and flee emerging markets in droves when things get shaky unexpectedly.
Crises in emerging markets can also be escalated by self-fulfilling expectations - if the market thinks en masse that there will be a crisis (and act on it) then there likely will be a crisis.
Untangling all the crises – currency, banking and debt
Currency crises (or balance of payment crises) were the main focus in earlier studies on emerging markets. But more recent studies have accounted for other types of crises that manifest in the banking system and from government debt. In all forms, financial crises are very costly for affected countries and unambiguously work to reduce economic growth.
Currency crises severely affect trade flows. Banking crises hamper credit supply and reduce output and investments. Debt crises drastically increase the cost of borrowing for national governments, and subsequent austerity measures to combat sovereign debt crises can be painful.
The underlying causes of these different types of crises do however share some commonalities and typically arise from firstly a long-running reliance on external financing that has been used to feed a domestic credit boom and an asset price bubble, followed by the eventual burst of the bubble and a rampant loss of investor confidence.
History tells us that crises rarely occur where economies are sound. The usual recipe for cooking up a crisis involves an economic downturn that comes after a prolonged economic boom that has been fuelled by cheap credit with an associated over-valued currency that can quickly deplete foreign reserves to defend when the tide turns. Turkey, Mexico and Argentina are all notable examples.
In recent years, more light has been shed on the sequencing of these financial crises. Research has documented that banking crises often precede or accompany debt and/or currency crises and a vicious cycle evolves as the latter crises can further deepen problems in the banking sector. Consistent with this, separate research has highlighted that governments (especially those in more politically unstable countries) can be short-sighted – they have a tendency to create repressed financial systems within which largely state or government owned domestic banks provide a ready financing channel for government expenditures.
As a result, the fates of banks and governments become intricately linked and there is a strong bilateral relationship between banking crises and sovereign debt crises. As a result governments easily over-borrow and are reluctant to reduce fiscal deficits even with unsustainably large debts on their balance sheets. The sovereign-banking nexus can create a dangerous amplification effect and the link needs to be weakened in the future.
Weaning off banks
A domestic banking crisis can adversely affect the fiscal strength of an emerging market and the ensuing sovereign credit deterioration can cause collateral damage to the banking system, making any future issuance of debt more difficult for all sectors of the economy.
In light of these issues, international policymakers need to work with governments in emerging economies to develop alternative channels for raising debt capital. Capital from non-bank financial institutions and retail investors would enhance risk sharing in these less developed financial systems.
Current banking regulations encouraging banks to hold government bonds should also be revisited to weaken the reliance of governments on bank financing. Emerging market crises are a global problem in an increasingly globalised world and coordinated efforts are required to ward off future crises.