A new emerging-market crisis, to follow that of 1998, has surfaced. The immediate Argentine crisis will be resolved. The politicians there have proposed budget cuts that, if supported domestically and implemented, will provide some relief for a while. But this won’t address Argentina’s growth dilemma. That’s a supply-side issue and the downside of a vastly overvalued currency. And it won’t do the trick of getting interest rates down to levels where Argentina could grow either. As for Turkey, I have no hope that interest rates there can be got down to sustainable levels either.
So ultimately both Argentina and Turkey will be forced to devalue (in Turkey’s case, again) and default (a move styled up as debt restructuring). There is not much the world can do about all this. IMF-style solutions have failed to achieve the triple objective for emerging markets like Turkey and Argentina of lowering interest rates, reviving growth and balancing the budget. Now these economies will have no access to international capital. So they will have to cut fiscal deficits and deflate domestically, while devaluing their currencies – in the case of Argentina, by 40% or so.
Alternatively, there is the option of populist policies that turn back the clock towards inflationary financing of budget deficits and capital controls. If that happens, emerging-market currencies will fall a lot further.
But does any of this matter for investors in Europe and the rest of the OECD? I don’t believe that the cave-in of these emerging markets poses a serious threat to my bullish scenario for US markets. Nor does the emerging-market crisis alter the risks to my vision of financial market and productivity-led economic recovery in the US.
There are several reasons for this. First, this crisis catches investors a lot less off-guard and with much smaller exposure than the 1997-98 crisis. Second, yet more money will flow to the US as a safe haven, boosting liquidity and the dollar. Third, emerging-market currencies will get cheaper and their exports more competitive, but these gains also accrue to global multinationals because emerging markets are the manufacturing end of the OECD economies. Fourth, interest rates in the US (and Europe) will move lower to help emerging markets and avert a global crisis of confidence. Fifth, cheaper imports from these countries will help lower OECD inflation. Finally, the hit to global demand from lower emerging-market growth is too small to matter much.
Another reason not to worry about contagion spreading from emerging markets to the G7, as it did in 1998, is that this crisis is different from the last one. The last crisis was caused by excessive amounts of underpriced debt and equity capital being invested at lousy rates of return. Much of this capital was debt. In general, capital was advanced on the assumption that Asian exchange rates would stay fixed to the dollar for ever. And it was cheaper to borrow in dollars than in local currency whether or not the borrower had dollar assets or revenues. Most didn’t. But when the returns on unproductive investments didn’t materialize, the local currency cracked and most borrowers became insolvent. Collapsing asset prices and investment then deflated the economies.
The crises in Argentina and Turkey are not a result of over-investment of cheap capital. These economies are, if anything, starved of investment. That means OECD investors have not been ploughing money into these countries. Indeed, their refusal to lend, except at high rates of interest, has forced Argentina and Turkey to try to adopt reforms, backed by the IMF. Unfortunately, any sign of wavering on implementing change has meant downfall.
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That’s because the primary common denominator of this crisis is a reliance on high-cost foreign capital to fund unsustainable external and fiscal deficits. These deficits are normally government’s fault.
Government dissaving means that there is an inadequate primary surplus to stabilise public debt to GDP. And public-sector borrowing crowds out productive investment. That kills growth. An economy with these characteristics is caught in an incipient public-sector debt trap. That’s because the cost of debt is higher than the rate of growth. So any budget deficit will automatically keep debt growing faster than GDP.
A contingent weakness is a currency peg that results in an unsustainably high exchange rate. That’s a structural weakness common to Argentina and Malaysia. Contagion is channelling along these arteries and will take out emerging markets that share these death characteristics. There may be momentary sighs of relief, as a result of attempts to bail out these emerging markets. Ultimately, though, the fundamentals of these economies will cause devaluation and default unless political transformation makes tough domestic reform and much smaller government an embedded policy.
Not all emerging markets have these death characteristics. South Africa looks set to run a big external surplus. Its government is a net saver. Sure, the country has a pile of challenges – but none of them are drivers of this crisis.
Mexico is a convergence story with the US. That ensures that the current-account deficit is more than covered by FDI inflows. The slowdown there is a mirror image of that of the US – not the harbinger of a current-account-driven peso collapse of as in 1995.
Poland’s big current-account deficit is shrinking fast as growth slows and should be down to below 5.5% of GDP this year from its peak in 1999 of 7.5% of GDP. Much slower than expected nominal GDP growth has pushed up the budget deficit, but new spending cuts just tabled by the government ahead of September’s election should limit the economic deficit to 3% of GDP. Above all, Poland remains a convergence play on the fast track to EU entry by mid-2004.
So this emerging-market crisis will kill those economies whose governments have not been willing to reduce their size and loosen their bureaucratic grip on the private sector. But it will not damage those emerging economies that have implemented reform. Contagion will be contained.
