Emerging markets can be a lot like teenagers: prone to accidents. They fall, get pushed by others, take reckless risks, and experience mood swings that make them hard to read and unpredictable. This doesn’t mean that mature nations always behave maturely—they too have accidents that, while less frequent, are deeply damaging to them and everyone else. The world is still suffering the consequences of the irresponsible behavior by banks, governments, and consumers in developed countries that triggered the great recession beginning in 2008. But while most advanced economies are now either recovering or no longer in recession, emerging markets are in turmoil. The value of their currencies is plummeting, inflation is up, economic growth is slowing down, and fiscal and trade deficits are soaring. Investors are taking their money and running.
Just a few years ago, as rich countries were crashing, emerging markets—the group of low- and middle-income countries that have experienced a long period of rapid growth and poverty alleviation—were seen as a source of stability for the global economy. Some of these countries even complained that the flood of foreign investment they were receiving was “overvaluing” their currencies, thus cheapening the prices of imports and making local products more expensive and less internationally competitive. Moreover, the Brazilian finance minister, Guido Mantega, denounced countries like the U.S. and China for launching “currency wars.” In his view, they were deliberately letting the value of their currencies decline relative to others in order to make their economies more internationally competitive, prompting other countries to retaliate and sparking a wave of “competitive devaluations” that were destabilizing the international economy.
Worried by the negative impact that massive inflows of foreign funds were having in boosting the value of their currencies, several governments enacted capital controls aimed at slowing down these foreign-investment flows. Today, they wish they had that problem. Instead, since last spring, they have been scrambling to curb the capital flight that is depleting their foreign reserves.
So what exactly happened to emerging markets? How could they have morphed so quickly from anchors of the global economy to threats to its stability? “Emerging markets, especially in Latin America, are much better at managing economic crises than prosperity,” Luis Alberto Moreno, the president of the Inter-American Development Bank, recently told me. According to Moreno, “We’ve come from an era of growth and increasing prosperity and, as the good situation starts to recede, the structural weaknesses that were always there and were masked by the growth resurface, become again apparent and impactful. Had emerging countries made the needed economic reforms, they would be less vulnerable to the periodic shocks that they periodically receive from abroad.”
A trifecta of forces is currently driving the emerging-market crisis: the “taper tantrum,” falling commodity prices, and the credit and fiscal hangover that followed the recent global growth spurt. The first was made in Washington and means that money is more expensive for everyone—and especially for emerging markets. The era of cheap and plentiful money fueled by the U.S. Federal Reserve’s quantitative easing has come to an end. The second was made in Beijing, as the Chinese government attempted to cool down a dangerously supercharged economy. Slower growth in China has lowered demand for the commodities that the giant country ravenously consumes, and decreased export revenues for the emerging markets that depend on exporting raw materials. “The abundance allowed them to live beyond their means without making the necessary reforms,” said Moreno. Moreover, many of these countries kept lax fiscal and monetary policies in place long after it was prudent to do so. Assuming that booms will never stop is not a good idea.
The two trends that will determine how this emerging-market turmoil will evolve, and how damaging it will be, can be summarized in two words: selectivity and contagion. Will investors be selective? Or will they treat all emerging markets indiscriminately, and thus pull their money out of countries ranging from Indonesia to Mexico to Ukraine regardless of the fact that some, like Mexico, have much better prospects than, say, Ukraine? And will the economic woes of emerging markets spread widely and reach advanced countries?
Some investors are convinced that there is no point in being selective. “We are in full-blown financial contagion mode,” Benoit Anne, head of emerging markets strategy at Societe Generale, told Reuters. “There is no point spending too much time trying to pick and choose when faced with a severe market crisis like the one we are witnessing.” “Right now,” he added, “sell everything.”
Yet the reality is that, so far, not all emerging markets have been roiled by the crisis with the same intensity, and some investors are differentiating between “bad” and “good” emerging markets. A ‘bad’ government is one that suffers from policy necrophilia—a passionate love for dead policies that have been repeatedly tried and have always failed. A ‘good’ one, by contrast, learns from its mistakes and adopts sustainable, result-driven policies, which translates into stronger economic fundamentals.
Take the cases of Argentina and Chile. The Argentine economy is in shambles, and it’s a safe bet that Cristina Fernández de Kirchner’s government will go down in history as one of the worst in a country cursed by an impressive lineup up catastrophic governments. Argentina is experiencing a massive episode of capital flight, and its international reserves have reached their lowest level in seven years despite the controls and punitive measures that the government has imposed to respond to an increasingly uncontainable crisis. Next door is Chile, a nation where successive governments on the left and right have overseen sustained economic growth and established a model economy for the rest of the world. Yes, like all emerging markets, Chile’s currency has lost value in the past few months, but the economic damage has been relatively mild. Overall, countries with strong economic fundamentals like Chile, Mexico, South Korea, and the Philippines are faring better than emerging markets like Argentina, Ukraine, and Venezuela. In fact, according to credit-rating agencies, the latter three are among the least creditworthy nations in the world and suffer from “serial economic mismanagement.”
So, will the contagion we’re seeing in emerging markets spread to their richer counterparts? It’s too soon to tell. Stock markets in the U.S., Europe, and Japan just recorded their worst earnings since January 2010—a telltale sign that the crisis in emerging markets has already hurt developed countries. But the consensus among experts is that, for now, it is unlikely that this crisis will escalate into a full-blown global crash. Let’s hope that’s the case. And let’s also remember that most experts did not think a subprime-mortgage crisis in California or a crashing Greece would have global consequences either.