EM vulnerability seems lower than in past crises…
A common feature of EM crises is that the countries most afflicted by capital outflows tend to be those with the largest external financing needs. A simple way of measuring those financing needs is the sum of the current account deficit plus the rollover of maturing external debt. And conventionally, a country is reckoned to be safer, the more that these borrowing needs are covered by available foreign exchange reserves.
On this measure, EM really is in a better position than it was during past crises, for the most part at least. In 1996 – the year before the Asian financial crisis – Indonesia’s FX reserves were sufficient to cover only 45% of the sum of its current account deficit and maturing external debt. Last year, that ratio was almost 290%. The numbers for Brazil paint a similar picture. In the early 2000s, when Brazil was faced by a series of crises, its FX reserves covered less than 70% of external financing needs. Last year, the ratio was 1,310%. The same basic story is true of Turkey, South Africa, India and plenty of other countries.
So the things we can measure – namely, the extent to which FX reserves can cover the financing gap – are arguably a source of hope for EM: things look better now than they did in past crises.
But in the crisis of 2013, there are some unique factors that are eroding the quality of the policy response that EM policymakers are assembling. And this results from the fact that this crisis is taking place against a background of very weak growth in EM.
…but weak EM growth constrains policymakers
Simply put, a country can produce a nasty current account deficit in one of two ways: either i) the economy is overheating, causing import growth to accelerate; or ii) exports are weak because global demand conditions are poor. If it’s the former, then it is easy for policymakers to put together a decisive response to deal with the current account deficit, and to end the vulnerabilities that it creates: the central bank will be happy to raise interest rates aggressively to address overheating concerns, and the government might also be willing to tighten fiscal policy for the same reasons. But when the deficit is generated by weak export growth, policymakers will be much less willing to do what’s needed to shrink the external financing gap. The cost of tightening is just too great, in terms of lost GDP growth. And, as I’ve explained recently, the problem in EM is emphatically driven by weak export growth.1
Central banks don’t want to tighten monetary policy…
The unwillingness of EM officials to tighten policy is as evident in central banks as it is in finance ministries. If you’re an EM central banker these days, you’re faced with two problems. One is that inflation is uncomfortably high. In Brazil, Russia, South Africa, Indonesia, India, and in plenty of other countries, inflation is above target, and that problem is only magnified by the exchange rate depreciation of recent months. But at the same time, the persistence of weak export growth makes central bankers reluctant to depress domestic spending, since that’s the main source of GDP growth these days. And central bankers feel perfectly entitled to think this way, because the intellectual climate in the past few years has moved away from ‘pure’ inflation targeting towards a greater emphasis on ‘flexible’ inflation targeting. There is barely an EM central banker on the planet these days who believes that their mandate is to pursue the inflation target no matter what the cost to the real economy.
As a result of this, inflation-adjusted interest rates remain pretty low in EM right now, and keep falling. The ex-ante real policy rate in Turkey, for example – that is, the policy rate deflated by consumer price index (CPI) expectations – is lower now than it was during the first few months of 2013. That’s also true of India, South Africa, Indonesia and Russia. The only large EM whose ex-ante real interest rate is higher now than it was in early 2013 is Brazil.
And even if growth in EM were strong enough to make central bankers more willing to raise rates, that might have some paradoxical consequences. In India, for example, the bulk of the foreign capital that has flowed during recent years went to the equity market. Some $200 billion of foreign capital is invested in Indian equities, compared with just over $20 billion in fixed income. Tighter monetary policy might help shrink the current account deficit and protect the Indian rupee, but the negative impact on GDP might lead growth-sensitive equity investors towards the exit. The lesson is: if you stabilise your currency at the cost of a recession, that recession might destabilise your currency!
…and governments don’t want to tighten fiscal policy
And it’s not only monetary conditions that stay loose, but also the fiscal stance. As I’ve highlighted in past research, all of the large EMs with current account deficits and capital outflows – Brazil, India, Indonesia, South Africa and Turkey – have important elections coming up in 2014. That argues against a tighter fiscal stance, particularly since governments seem keen on pushing a slightly looser fiscal policy in any case in order to compensate for weak external demand and to plug their admittedly huge infrastructure deficits.
Maybe currency depreciation isn’t a bad thing?
And there is another factor that helps EM policymakers dither in their policy response to the capital outflows, namely the feeling that ‘maybe it’s not such a bad thing to have a cheaper currency?’ We’re entering a world where capital flows to EM will be scarcer, where the outlook for EM exports is unclear, and where risks to global growth – due in particular to ‘China risk’ – have by no means disappeared. So, EM policymakers might be well advised to tolerate a reasonable amount of currency depreciation to help recognise these new realities.
But how much is reasonable? Data from the Bank for International Settlements show that the Brazilian Real has depreciated by around 10% in inflation-adjusted, trade-weighted terms since early 2013. But that still leaves the currency almost 50% more expensive than it was on average between 2002 and 2005. That’s an extreme example, but the point is this: we’re in a world where it’s quite difficult to judge at what stage a currency has ‘overshot’, i.e., where it is so undeniably cheap that investors will want to own it.
And the lack of clarity about what ‘equilibrium’ looks like is the real problem that EM faces right now. Investors used to think they understood the EM story: strong, export-led growth, reserves accumulation, currency appreciation. That story no longer seems true, but investors are unsure what might replace it. One hope is that EM might be ‘bailed out’ by stronger export growth as the recovery in G10 takes hold. But the growth rate of G10 import volumes has been negative since August 2012. If there is good news out there for EM exporters, we haven’t seen it yet.
