What’s Behind the Emerging-Market Meltdown

Emerging-market economies had a brutal week. For years, during the crash and its aftermath, they did well as the advanced economies slumped. Recently, not so much. Many developing countries are seeing their currencies drop and their bonds and equities hammered. Just as the global recovery appeared to be strengthening, a fresh source of instability has presented itself.

The issue now is how to keep the turmoil from derailing the global expansion. In a way, this was not an unexpected development: The recession in the advanced economies caused central banks to push short-term interest rates to zero and buy assets to drive long-term rates down as well. Capital flowed to the developing world in search of better returns. As investors prepare for a resumption of normal monetary policy, demand for emerging-market assets is bound to fall. The question has always been whether this adjustment would be smooth or abrupt.

The problem is that two things are amplifying the adjustment of capital flows: first, the dependence of global capital markets on the dollar, and hence on the policies of the U.S. Federal Reserve; and second, policy mistakes in some of the most-watched developing economies. In the short term, there’s little to be done about the dollar’s destabilizing pre-eminence. But economic reform in some of the main emerging-market economies, desirable in its own right, would help calm nerves.

Paradoxically, the U.S. market crash of 2007 and 2008 entrenched the dollar’s global dominance. Investors sought safety, and U.S. government debt remains the world’s safest asset. Despite tremendous federal borrowing, U.S. debt was soon in short supply. The Fed’s quantitative easing took trillions out of the market, and emerging-market governments bought dollars as a cushion against bad news and to hold their currencies (and export prices) down.

As a result, the emerging markets are unduly sensitive to fluctuations — real or imagined — in U.S. monetary policy. The Fed has recently begun to pivot away from quantitative easing, signaling that the era of extraordinarily loose U.S. monetary policy will come to an end. This is making investors think twice about putting their money in developing countries.

The Fed has begun to taper QE too soon — inflation in the U.S. is still low, and the labor market is still slack. On the other hand, the reduction in the pace of asset purchases is gentle (some would say to a fault), and at some point winding down the Fed’s unorthodox measures was going to be necessary.

The remedy for undue global sensitivity to U.S. monetary policy isn’t a different approach by the Fed; rather, it’s burden-sharing. Eventually, other currencies, such as the euro and the renminbi, need to function alongside the dollar as reserve currencies. In the meantime, better U.S. fiscal policy – – less budget contraction now, when the economy needs stimulus, and more later — would also lighten the Fed’s load.

There’s also more emerging-market governments can do. They should recognize that this week’s financial-market turmoil was, to varying degrees, their own fault. Argentina, which felt the full force of the storm with collapsing bond and equity prices and a steeply devalued peso, is a textbook case of economic mismanagement. No mistake has been left unmade — including cooking the books about the true rate of inflation.

There’s news to concern investors in other and more important emerging markets, too. Growth in China has been expected to slow for years: It now appears to be happening, and the government’s ability to manage the necessary economic restructuring is in doubt. The world’s second-worst-performing currency lately is the Turkish lira: Political protests, corruption scandals and flailing leadership are calling the country’s economic prospects, and its place in Europe, into question. Russia is stumbling. So is Brazil.

We’ll have more to say about these emerging economies in the coming days as we look at the stress points of a post-QE world. For now, suffice to say, the best way for emerging-market governments to restore confidence would be to improve their policies. In this week’s financial turmoil, factors beyond their control were in play, but they aren’t innocent bystanders, and they aren’t powerless.

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