An EM credit crunch, not a sudden stop
February 16, 2014 1:23 pm
by David Firn
After the latest rally, emerging assets have performed almost in line with developed equities since the beginning of the year, and there has been little sign of the sudden jump in correlations between countries with good and bad fundamentals that is the hallmark of a genuine crisis in the emerging world. After all the hype, surely that cannot be the end of it, can it?
Probably not. In the last era of EM crises, from Mexico in 1994 to Asia in 1997 and Russia and Brazil in 1998, the story involved many chapters during which the worst seemed to be over, only for each ensuing wave to prove eventually more destructive than the last. By the time that the Russian default took down Long-Term Capital Management in August 1998, the crisis had finally grown to a scale that had enveloped the developed markets, requiring emergency action by the Fed to bring it under control. Then, and only then, did it end.
Are there any implications for today from the rolling crises of the 1990s? Like now, the Fed was withdrawing liquidity, making it harder for EM deficit countries to finance their trade deficits. Also like now, the Fed proceeded on its domestic path apparently oblivious to the problems in the emerging world, at least until the final climax. US interest rates were rising, faster than seems likely to happen this time, and this exposed underlying vulnerabilities in many countries that had earlier seemed in robust health.
Stanley Fischer, likely to be confirmed as the new Vice Chairman of the Fed this month, was the key official at the IMF throughout the 1990s crisis. His reflections, in a series of lectures at the LSE in 2001, are well worth re-examining. His description of the typical response of policy makers caught in a sudden crisis is particularly apt:
“It is hard to describe the state of shock of policymakers beset by a crisis that has destroyed their entire policy framework. They start by blaming everything and everyone but themselves, they resent the need to call on outside help, and find it very difficult to think realistically. A bit later the serious policymakers get down to work.”
It is the same this time. The right policy responses will take a while to emerge, and will be made more difficult, as in the 1990s, by elections in many of the most troubled economies. In the next 18 months, there are national elections in India, Brazil, Indonesia, Hungary, Turkey and several others. Strategic errors in economic management are more likely at times of political stress.
Fischer’s account of the last crisis, even from his unique vantage point inside the IMF, emphasises how difficult it can be to discern what is really going on in real time. His thinking often had to rely on newspaper reports and off-the-cuff comments by hedge fund managers, while governments deliberately concealed from him the extent of their problems with foreign exchange reserves and bad bank loans.
Confidence and contagion are mercurial beasts. Even with the benefit of hindsight, Fischer is not completely confident about the underlying causes of the last crisis. How much harder it is to predict the course of a such a crisis, especially from outside the official sector.
However, some patterns do emerge fairly clearly. The 1990s debacle was triggered mainly by what has become known as a “sudden stop” in capital flows from the DMs to the EMs. It was essentially a capital account crisis, more than any other before or since. The sudden stop resulted in a collapse in exchange rate regimes, which had mainly involved fixed or crawling pegs against the dollar.
The outright collapse in policy regimes caused implosions of domestic and international confidence, and massive devaluations which hugely increased the share of external debt in GDP. This triggered “balance sheet recessions” with widespread corporate and financial sector bankruptcies.
Many economists, notably Joe Stiglitz [1], blame the IMF itself for the dire consequences of the 1990s shocks. But Fischer defends the IMF strategy, based on fiscal and monetary tightening, structural reform, exchange rate flexibility and an absence of capital controls. Fischer is probably right that all alternative policies would have been worse, but the IMF’s “success” was partial at best: real GDP fell by 10 percent or more over a couple of years in the crisis countries and trend growth rates over the next decade dropped by 3 percentage points.
Nevertheless, some durable lessons were learned. In the prelude to the current crisis, exchange rates were more flexible, and they have acted as shock absorbers, which were unavailable last time. These are admittedly flawed shock absorbers, as Dani Rodrik argues here, but they are much better than nothing.
Furthermore, international reserves are much higher, and external debt is (as far as we can tell) probably somewhat lower than in the 1990s.
The IMF formula of higher interest rates and tighter fiscal policy is being implemented voluntarily in many countries, albeit rather slowly. And while there has been a major reversal in capital flows, there have been no sudden stops to rival those in the 1990s. Policy regimes have responded to the forces of the international capital markets, rather than collapsing in front of them.
So can we be confident that the outcome will be less protracted this time?
One aspect of the problem suggests not. That is the domestic credit bubbles which have taken hold in many EMs, especially in Asia. This seems to be a different order of magnitude from anything that happened in the 1990s, and the consequences for financial systems in countries like India and Turkey, where recessions are taking hold, are unknowable at this stage.
In attempting to escape from the consequences of the credit bubbles, and the resulting Great Recession in the developed world, many emerging economies may have ended up creating similar problems of their own. The external financing aspects of the EM problem may well be less than in the 1990s, but the internal aspects could take longer to handle. Credit standards in the EM banking sectors are now tightening markedly, in contrast to the easing now underway in the DMs [2]. This needs to change before growth in the EM economies can recover.
In summary, while the emerging markets may escape the sudden stops of the 1990s, they may be facing a domestic credit crunch instead.
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Footnotes
[1] Joe Stiglitz’s book“Globalisation and Its Discontents”, published in 2002, sharply criticised the IMF for its approach during the 1990s crisis, and triggered one of the most bitter exchanges in the recent history of macro-economics. See this critique of Stiglitz by Ken Rogoff, when the latter was at the IMF. For a balanced assessment of the Stiglitz case against the IMF, see this review by Barry Eichengreen.
[2] The graph shows the difference between the demand for credit and the availability of credit supply, with higher numbers indicating easier credit availability. The calculations are by David Hensley at J.P. Morgan, from the IIF survey of credit standards.
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