A Textbook Emerging Market Crisis? Not Exactly

SMITH BRAIN TRUST – A widening emerging market crisis is stirring uncertainty among investors. In many ways, this crisis looks like many we’ve seen play out before in the developing world. Then again, explains Maryland Smith’s Pablo Slutzky, there are factors that make this time seem very different.

“What we are seeing is kind of the same story again and again,” says Slutzky, assistant professor of Finance at the University of Maryland’s Robert H. Smith School of Business. “We had the Mexican crisis in 1995; the Russian crisis in 1998. I’m from Argentina, and we also had a crisis in 2002.”

First, he explains, comes the crisis, often one driven, as this one is, by a tightening in global liquidity, which restrains capital inflows and results in higher borrowing costs. Then, comes the larger, overarching worry – contagion, the fear that this crisis will spread around the globe, infecting other emerging economies.

Only, this time, Slutzky explains, there are also rising global trade tensions and geopolitical risks that threaten to deepen and prolong the crisis impacting the world’s faster-growing but more fragile economies.

A crisis in the making

The latest crisis began in Turkey, which like many emerging market economies had been piling on debt in recent years, much of it denominated in U.S. dollars because, Slutzky explains, interest rates in the United States “were extremely low” – near zero percent – and had stayed that way for a long time.

In the early years of the global recovery, emerging market countries saw relatively robust economic growth. Feeling generally flush with cash, they began importing more than they exported, creating what’s known as a current account deficit. To cover the subsequent gaps, Slutzky says, the countries had to borrow. “And they were borrowing more and more in U.S. dollars,” he explains, taking advantage of those low interest rates.

Over the past 10 years, in fact, Turkey and other emerging markets tripled their debt loads, to $63 trillion, from $21 trillion.

Eventually, the party ends

Those ultralow interest rates were bound to end sometime. And that’s happening. The Federal Reserve increased its key interest rate to 2 percent last June.

It’s been a double-whammy for emerging market economies. Those higher interest rates began making it more expensive for emerging markets to cover their debts. And, they created capital flight, as global investors shunned riskier emerging market bonds and flocked to the safety of U.S. Treasurys, which for the first time in years began offering a fair bit of yield.

The capital flight has inevitably resulted in currency depreciation. That, too, makes it harder – more expensive – for emerging markets to repay their debt obligations. “We are seeing this in Turkey, in Argentina. You can see the same thing with the Indian rupee, the South African rand, the Brazilian real, all the currencies have depreciated in the past few months,” Slutzky says.

What happens next

“Then, fear appears,” says Slutzky.

As debt costs rise for emerging economies, global investors begin to worry about the potential risk of default. They exit their remaining holdings, in a move that drags down the country’s currency even more.

“It is a vicious cycle because as more money leaves the country, there is more currency depreciation and an even higher fear of default,” Slutzky says. “The more people worry about default, the more they charge an emerging market country to borrow. It goes on and on.”

Last week, Turkey’s central bank, reacting to its burgeoning crisis, raised its key interest rate to 24 percent, in a bid to attract foreign investment. Argentina’s central bank, meanwhile, raised its key rate to 60 percent.

Higher interest rates, the theory goes, will lure outside investors who want higher yields and are willing to stomach some risk. As investors flock to new Turkish debt issues, priced in the Turkish currency, they must buy lira, which props up the currency’s value.

The downside

“The problem is that when you increase interest rates, it becomes expensive for your country’s firms to borrow and invest,” Slutzky explains.

That hurts economic growth and adds to those investor worries about the country’s ability to pay its debt obligations, since the main source of funds for the government is taxes. It’s a continuation of that vicious cycle.

“So now the emerging markets will suffer and go through a lot of pain. The currency is depreciated, and so it is more expensive to import goods,” he says. “However, the country’s exported goods are suddenly cheaper and more attractive to other countries because of the depreciation in the currency.”

Pricey imports will see a fall in demand, while exports will see a rise. In the short term, there will be a slowdown in the economy, a devaluation, but in the medium term, the current account will be pushed toward a balanced or even a surplus position. “Usually this is what happens,” he says, “in as little as a year or two. Usually it's quite fast. Emerging markets can have huge falls and rapid recoveries.”

Why this time may be different

Such turmoil is nonetheless worrisome. As Turkey’s crisis began to unfold this summer, analysts were studying contagion risk. Some asked whether the widening crisis might threaten the global economy.

Slutzky says those fears aren’t unfounded. “There are a lot of factors going on this time and things aren’t simple,” he says. “Today, there is a trade war involving some of the largest economies. There is geopolitical risk, risks we haven’t had in previous crises.”

Meanwhile, however, U.S. economic growth is at a multiyear high and unemployment is at a multiyear low. Absent a trade war, those factors would likely give the global economy something of a cushion.

“My guess is that we are going to see a significant decline in GDP growth in emerging markets. It might last a couple of years, and then there will be a recovery,” he says. “But this time, with other risk factors affecting the global economy, it's harder to tell what is going to happen.”