The Financial Crisis and Emerging Marketsby Arvind Subramanian | October 24th, 2008 | 11:12 am
The financial crisis has now caught up with emerging markets—with a vengeance. Wherever you look, in Eastern Europe and the Baltics, Latin America or Asia, the financial carnage is evident. Even China, the most immune to contagion, is going to see its growth decline from 12 percent to 9 percent. Elsewhere, panic in global financial markets has compelled the International Monetary Fund (IMF), which previously was trying to adapt to a no-crisis world, back in the lending and financial rescue business. While the IMF engages in talks with Hungary, Iceland, Ukraine, Pakistan, and other countries, the United States and its European partners have begun discussions about stepping in with credit lifelines to middle income developing countries in desperate need of dollar loans to avoid default.
How did this happen? Several factors were at work to create a crisis for countries that have enjoyed phenomenal growth over the last decade.
Trade contagion: This crisis versus Asian financial crisis
Will this crisis scar emerging markets as much as the one in the late 1990s? To be sure, there is one big difference that makes the current crisis less fearsome: Many countries have cushioned themselves against shocks by building up a war chest of foreign exchange reserves and healthier sovereign balance sheets.
But there is one big difference that will make the current crisis more difficult: Today, the external environment for emerging markets—the economic health of their rich country trading partners—is considerably worse. The rich countries are all already in, or heading toward, a deep and prolonged recession. Consider this: Counting the crisis year, 1998, and the two following years, the advanced economies grew at about 3.3 percent per annum. For the comparable period of this crisis (say 2008–2010), that number is likely to be smaller, perhaps barely in positive territory.
Advanced economies account for a smaller share of emerging markets’ exports and trade today than ten years ago. Even so, worsening growth in advanced economies makes the trade contagion to emerging markets more severe. One clear sign of the danger is the collapsing price of commodities, which have declined by over 50 percent since their highs this summer. As a result, emerging market exporters of commodities—for example, Russia, Brazil, and Argentina—face a decline in their export earnings.
Mercantilism: Gross versus net flows
One lesson that emerging markets, particularly in Asia, drew from the 1990s crisis was to self-insure themselves; that is, they decided to build up huge piles of foreign exchange reserves as a buffer against future financial winds. This was achieved in part by mercantilist policies that kept exchange rates competitive, boosted exports and muted imports. This strategy was dubbed by some Bretton Woods II because it involved de facto or de jure pegs to the dollar. This approach had the following impact: It reduced the net flows of capital into emerging markets; and in many cases, most strikingly for China, it actually made net flows go uphill—from poorer to richer countries. But the interesting thing was that emerging market countries did not reduce their gross flows; indeed, gross capital inflows rose sharply since the last crisis.
Now, what we have learned about financial crises is that when there is a collapse of confidence, gross flows matter a lot. If domestic banks or corporations fund themselves in foreign currency, they need to roll these over as the obligations related to gross flows fall due. In an environment of across-the-board deleveraging and flight to safety, rolling over is far from easy, and uncertainty about rolling over aggravates the loss in confidence. Thus, it is not enough to reduce net inflows or generate net outflows to insulate oneself from financial contagion; effective insulation apparently also requires minimizing gross flows, especially gross inflows. Mercantilism, which works on net flows, is insufficient as an insulation or buffering strategy. Brazil, India, and Korea are examples of countries that had small (or even negative) net inflows but they have not escaped financial contagion because they had large gross inflows.
China, of course, had large net outflows but also minimized gross inflows. It has, therefore, also been the country that has been most immune from financial contagion, despite the fact that it is facing an economic slowdown. But here’s the rub: while mercantilism, and the associated pile of foreign reserves, provides some cushion against financial contagion, it actually increases vulnerability to trade contagion: the more the exports, the more dependent a country is on the health of foreign partners, and the more it suffers when partner country economies’ head south. What you gain on the swings you seem to lose on the roundabaouts.
Either way, there is no getting away from interdependence. Emerging markets and their trading partners are in Bob Dylan’s words “sooo entwined.”