Thursday, 9 April 2009

Hopelessness At The Bottom Of The Pit

Emerging markets have always been an enigma for economists. They are poor, but unlike the ‘poor’ countries, they have a lot of economic dynamism. They have functioning governments, and they have economic institutions such as a central bank, or a stock exchange, like the developed world, but these are often erratic in their effectiveness. But most of all, these countries, should they be in East Asia, Central Europe, Latin America, or southern Africa, always tended to produce macroeconomic numbers that would be impossible for mature economies. Our models and theories that work for the developed world (or at least used to) were unable to explain a host of phenomenon in the emerging markets. Hence the regular use of the adjective ‘miracle’.

For instance, in a developed country, it is impossible to have the kind of simultaneous fall of budget deficit, current account deficit, inflation, and unemployment that is frequently observed in emerging economies. It just does not happen. Moreover, a host of theories tell us why it should and will not happen. Unless, of course, you are undergoing rapid structural change in your economy, a typical dynamics of emerging markets. And there you are, a miracle is born.

Now, we have a couple of negative miracles on our hand... Similar to the positive versions, economics has hardly any standardised handle on the problem.

One of the very interesting phenomena in the upswing phase of emerging market development is the switch from export momentum to domestic one. It is interesting, for in almost all the cases, much of the domestic demand that is seen as inherent, home grown etc., keeps being dependent on export performance. It is easier to see this in smaller countries, such as Thailand, Poland, or South Africa, but the past two years also shed light on the very same phenomenon in some of the larger ones, such as Brazil, Russia, and - increasingly obviously - China. Remember the arguments about domestic dynamics in the emerging markets being the new global driving force, voiced at the beginning of this crisis? (This myth fully endorsed by the political classes of the above mentioned emerging markets, less for lack of understanding, and more for good old fashioned political populism. And they were just warming up.)

The trouble is that once you realise that domestic demand is indirectly linked to export performance to larger extent than you previously thought (and overall, to a very large extent, especially in the longer run), then your options to weather the crisis are suddenly radically diminished. Especially this kind of crisis, where the global economy is shrinking to such an extent. For all economies, emerging or mature, this translates into policies that try to generate domestic demand, rather than export competitiveness. At first, you would try the old fashioned way: monetary easing with fiscal tightening (or at least the promise of the latter). Then, when it does not work (independent whether the reason for disfunctionality lies in the monetary transmission mechanism being screwed up by the local excesses of the capital markets, or the lack of a global policy framework), you move on to the next level: fiscal stimulus. It is less sophisticated, bears more long term risks for your economic system, but hey, that’s what’s left.

This leaves emerging markets in an odd place. Their monetary toolbox had already been generally weaker than that of mature economies. Furthermore, they do not have the advantage of them being the ‘safety’ bit in ‘flight to safety’, thus liquidity dries up even faster. And as domestic demand turns out to be much more dependent on the - collapsing - exports, they would need disproportionately large fiscal stimuli. In most emerging markets, the space for the latter had already been tight. The government spending needs - and demands - during the rapid structural change years had been phenomenal, pretty much exhausting the fiscal capacities. And of course there are those that had been irresponsible on top of it (Hungary, Argentina, Iceland, Ukraine, I am talking to you!).

So, you are an emerging market crisis-policy-maker. What can you do? You will certainly go to the end of your fiscal abilities, if there is any left. But, for most, this direction will yield very little. The only strategy there is left for you to play is going back to ‘emerging markets amidst globalisation 101’, and return to generating export momentum. This is a tall order, for the global markets are contracting, and countries are locking up. However, you do not have much else left. (Especially, if the crisis lasts much longer, and even those little remaining fiscal capacities will have been used up.) Some emerging markets will be able to play this game very well. Look at the behaviour of Singapore during crises of the past decades, for a textbook case. Some others, however, will have major problems, for their past lack of structural reforms and the tax legacy of their past, and current, fiscal overspending will leave no room for measures to improve export competitiveness.

Significant currency devaluation (with or without government default), or serious social discontent will follow. Or both.


  1. Interesting post... it would seem though that the currency devaluation game is global and not restricted to emerging markets (look at the Swiss)

    Considering that some emerging countries that are highly indebted in foreign currency and thus are limited in their capacity to devalue, one could even argue that the emerging world is going to lose, rahter than gain competitiveness in such a "race to weakness".

  2. nice piece.

    yet,should the title not read instead: hopelessness amidst the fall?

  3. One question: does the previous domestic savings / saving-rates in these countries make any difference? Or you are talking about an 'emerging phase' when these are negligible / weak / non-existent?

    And a comment re-'the fall':

    l’important c’est pas la chute :
    --c’est l’atterissage..


  4. @Anonymous first comment: I agree that the devaluation game will go way beyond the emerging markets. This will be a sort of Race-To-Devalue.

    If it will really happen in earnest, the consequences will be really bad: this will be a real global currency tragedy of commons game. The upside is that in this scenario arguing for a new currency framework (which I expect to be inevitable at one point) will be much easier.

    Re the emerging markets with heavy debt burden. I see a merit to the argument, but with those in real trouble could not really hold. Who on earth will bet on these currencies keeping up in a global devaluation meltdown? The only difference will be that these currencies will fall themselves, you will not have to manipulate them down...

    I wonder, though, what the inflation impact of such a global Race-To-Depreciate scenario would be. Anti inflationary monetary policy would be pretty impossible if all the others were trying to devalue their currencies against you.

  5. @Gergo:

    Saving rates are a tricky thing. They could, and do, work both ways in this crisis.

  6. A little scare mongering for Easter?

    There is no way the US will let Ukraine fall. There is no way the EU will let Iceland or Hungary fall. Geopolitics is geopolitics, even amidst a crisis.

  7. @Dragon_tamer: Unless of course there is nothing to save these countries with. You rightly claim that geopolitics is to stay even during a crisis, but surely it will be constrained by the size of the purse where the money comes from.

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