Here we go again.
First, money poured into emerging markets when it looked like they offered juicy returns. Then it poured out after they didn't. Currencies are collapsing. Stock markets are falling. And central banks are sacrificing the real economy to save the exchange rate.
We've seen this movie before. It was called the East Asian financial crisis, back in 1997. But, for once, the sequel won't be worse than the original. Emerging markets don't have enough foreign-money debt this time around to make their falling currencies much of a concern. What is a concern is whether their central bankers realize this. They might overreact—they might already be—and raise rates to prop up their currencies, when they should be lowering them to prop up their economies.
Now, emerging market currencies have been in a world of pain since last May. That's when Ben Bernanke first hinted that the Fed would soon draw down—or "taper"—its bond purchases. If that meant the Fed would start raising rates sooner too, as markets assumed it did, there wouldn't be any need to park money overseas to get a decent return. You could do that in the U.S. So investors pulled their money out just as quickly as they had moved it in—and emerging market currencies fell. You can see just how much they fell against the dollar in the chart below, which I've updated from The Economist.
So how did we get here, and just how much should the non-currency traders among us worry?
1. It actually began before the financial crisis. Capital gushed into emerging markets—particularly commodities—between 2004 and 2008, even as the Fed raised rates from 1 to 5.25 percent. It was BRICs euphoria, and nothing could stop it. Nothing except Lehman. But once it became clear the world would not, in fact, end, capital went back overseas to rekindle the old magic (and find better returns than the Fed's zero percent interest rates).* It went back to emerging markets. Higher growth and higher interest rates there looked like no-brainers compared to the low growth and low rates in the at-best-moribund U.S. and Europe.
2. That left the emerging markets with a dilemma: They could raise rates and get a foreign credit boom, or cut rates and have a domestic credit boom. If their central banks kept, or raised, rates high where they "should" have been, it would have only attracted more "hot money"—quick, speculative capital looking for the best return—from abroad. This would have made their exports even less competitive by pushing up their currencies more, and set off a lending boom that could reverse itself at the click of a mouse.
But it was a bit of a catch-22. If their central banks kept rates lower than they should have, it would have made their economies less attractive to yield-hungry foreign investors. Less capital would have flowed in, and their exports wouldn't have been as priced out by a too-high currency—but persistently too-low rates would have risked inflation and a credit boom of their own making.
They chose door number 2. They chose it, because they had seen what hot money could do to an economy when it got scared: the East Asian financial crisis had created mini (and in Indonesia's case, not-so-mini) depressions back in 1997. Instead, emerging markets decided to try to keep their currencies low to run big trade surpluses, and build up rainy day funds of foreign reserves. So when the Fed lowered rates in 2003, they did too. The same in 2008. But, as you can see in the chart below from the World Bank, these low rates that made sense for the U.S. didn't make sense for emerging markets. They were too low.
3. But there was a door number 3. Emerging markets could have stopped hot money from coming in. Such "capital controls" would have let them raise rates as needed without worrying about foreigners pushing up their currencies or blowing bubbles. Indeed, China uses them, and Brazil kind of did too with its now-defunct financial transactions tax. But most emerging markets didn't. Capital controls were too heretical, just not what you were supposed to do (even though now even the IMF thinks they're okay).
4. So emerging markets had big domestic credit parties that started to run out in 2011. But then foreign money—yes, some of it from QE—kept the party going awhile longer. That ended last May, though, when Bernanke said the Fed would soon start drawing down QE. Hot money ran for the door, currencies dropped, and the weakness that had been there all along became obvious. Particularly, Barry Eichengreen found, in countries that 1) were borrowing from abroad, and 2) had big enough financial markets that it was easy to sell.
5. The "taper," though, didn't come as soon as expected. Emerging markets got a reprieve. But in December the Fed did start reducing its bond-buying. And unemployment started falling fast enough that markets wondered if rates would rise sooner than expected. That's been enough to get investors to move their money back to the U.S., especially when the emerging markets' engine, China, is looking wobbly. Emerging market currencies, of course, started dropping again.
6. But falling currencies are only a problem if you borrow in another one. Emerging markets made that mistake in 1997, but they didn't this time. Well, aside from Turkey, they didn't. As you can see in the chart below from Matt Phillips, Turkish companies went on a foreign borrowing binge the past few years. That's why their central bank hiked rates so much to try to keep their currency from falling any more: It's hard to pay back your dollar debts when your Turkish liras don't buy as many dollars.
7. The danger isn't slumping currencies. The danger is overreacting to slumping currencies. Emerging market central banks have been raising rates to prop up their currencies, even though they don't have much foreign-money debt and should be cutting rates to offset slowing growth. Remember, emerging markets make up half of world GDP, so if they all tighten policy at once—let alone when they should be doing the opposite—the hit to global demand could be significant.
8. There are some outliers here. Political turmoil has turned into economic turmoil for Ukraine and Thailand. Turkey a little bit too. And Argentina is an economic basketcase, because it always is. (Put it this way: the most responsible thing Argentina has done the past century is default on its debt in 2002). It had an overvalued exchange rate and high inflation, both of which it tried to wish away. Eventually it couldn't, and its currency really collapsed overnight.
Lehman conditioned us to always look for the next domino. But sometimes a falling currency is just a falling currency. Some emerging markets are going to have a tough time with foreign-money debt—damned if they do raise rates, and damned if they don't—but for most the danger is doing too much.
*This section has been updated. The original incorrectly stated that capital inflows started after the financial crisis when they actually started before.
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