Battle-weary policy makers do not want to believe that an emerging market crisis is possible. But there are striking resemblances now to the economic troubles these countries suffered in the 1990s

Sept. 9, 2013, 6:31 a.m. EDT

No country is safe from emerging market meltdown

Commentary: Repeat of 1990s debt crisis would threaten global growth

By Satyajit Das

SYDNEY (MarketWatch) — Battle-weary policy makers do not want to believe that an emerging market crisis is possible. But there are striking resemblances now to the economic troubles these countries suffered in the 1990s. Then, loose monetary policies pursued by the Federal Reserve and the Bank of Japan brought large capital inflows into emerging markets, especially Asia. In 1994, Federal Reserve Chairman Alan Greenspan withdrew liquidity, resulting in a doubling of U.S. interest rates over 12 months. In the 1994 ‘Great Bond Massacre’, holders of Treasury bonds suffered losses of around $600 billion. Trading losses led to the bankruptcy of Orange County in California, the effective closure of Kidder Peabody and failures of many investment funds.The Fed’s move triggered a crisis in Mexico and across Latin America. It precipitated the Asian monetary crisis, requiring International Monetary Fund bailouts for Indonesia, South Korea and Thailand. Asia took more than a decade to recover from the economic losses.

Repeat underperformance

There’s reason now to fear a rerun of this economic collapse in the emerging markets, triggered by rapid capital outflows and a rising U.S. dollar.

The basic trajectory is familiar: Weaknesses in the real economy and financial vulnerabilities rapidly feed each other in a vicious cycle. Even if the reduction of excessive monetary accommodation in developed economies is slow or deferred, the fundamental frailties of emerging markets — current account deficits, inadequate investment returns and high debt levels — will prove problematic. Read more: Emerging markets are crumbling like BRICs.

Capital withdrawals will cause currency weakness, which, in turn, will drive falls in asset prices, such as bonds, stocks and property. Decreased availability of finance and higher funding costs will increase pressure on overextended borrowers, triggering banking problems which feed back into the real economy. Credit rating and investment downgrades will extend the cycle through repeated iterations.

Policy responses will only compound the problems.

Central bank currency purchases, money market intervention or capital controls will reduce reserves or accelerate capital outflow. Higher interest rates to support the currency and counter imported inflation will reduce growth, exacerbating the problems of high debt. India, Indonesia, Thailand, Brazil, Peru and Turkey have implemented some of these measures.

A weaker currency will affect prices of staples, food, cooking oil and gasoline. Subsidies to lower prices will weaken public finances. Support of the financial system and the broader economy will pressure government balance sheets.

The “this time it’s different” crowd argue that critical vulnerabilities — fixed exchange rates, low foreign-exchange reserves, foreign currency debt — have been addressed, avoiding another emerging market “death spiral.”

This is an overly optimistic view. Structural changes may slow the onset of the crisis. But real economy and financial weaknesses heighten the risks.

While local currency debt has increased, levels of unhedged foreign currency debt are significant. Where the debt is denominated in local currency, foreign ownership is significant, especially in Malaysia, Indonesia, Mexico, Poland, Turkey and South Africa. Currency weakness will cause foreign investors to exit, increasing borrowing costs and decreasing funding availability. Read more: Developing nations buckling under debt burden.

Fundamental weaknesses and a weak external environment limit policy options. The IMF’s capacity to assist is constrained because of concurrent crises, especially in Europe.

Economic blowback

At the annual central bankers meeting at Jackson Hole in August, Western policy makers denied the role of developed economies in the problems now facing emerging markets, arguing that the policies had “benefitted” emerging markets. But developed economies now face serious economic blowback.

Since 2008, emerging markets have contributed around 60%-70% of global economic growth. A slowdown will rapidly affect developed economies. Demand for exports, which have boosted economic activity, will decrease. Earnings of multinational businesses will fall as earnings from overseas operations decline. Investment losses will affect pension funds, investment managers and individual investors. Loans and trading losses will affect international banks active in emerging markets.

Emerging markets have around $7.4 trillion in foreign exchange reserves, invested primarily in U.S., Japanese, euro zone and U.K. government securities. If emerging-market central banks move to sell these holdings to support their weak currencies or the domestic economy, then the sharp rise in interest rates will attenuate the increase resulting from the reduction of monetary stimulus. This will result in immediate large losses to holders. It will also increase financial stress, adversely affecting the fragile recovery in developed economies.

Emerging market currency weakness is driving a rise in major currencies, such as the U.S. dollar. This will erode improvements in cost structures and competitiveness engineered through currency devaluation by low interest rates and quantitative easing. The higher dollar would truncate any nascent recovery.

Over time, the destabilizing effect of national actions and complex policy cross-currents may accelerate the move to closed economies, damaging global growth prospects. And like a drowning man grabbing another barely able to swim, the policies may ensure that both drown together.

Satyajit Das is a former banker and author of “Extreme Money” and “Traders, Guns & Money.”