September 29, 2022 | 14:25
Emerging Markets Look to Lessons from Crises Past
Concerns that emerging markets (EMs) are about to enter a crisis have yet (and are unlikely) to fade away, especially when global financial risk aversion escalates as is presently the case. However, we think that the prospect of the EM world experiencing some form of a large, synchronized financial crisis (e.g., sovereign, bank or balance of payments) is fairly remote. This is not to say there won’t be some casualties, especially in EMs with more unstable political regimes. Indeed, so-called frontier markets like Pakistan, Sri Lanka and Zambia recently needed to be bailed out by the IMF.
Though most major EMs have broadly recovered from the pandemic, they may not be out of the woods yet, especially given the growing prospects of a global economic recession. Crucially, EMs are still much more vulnerable to capital outflows than their wealthier developed market peers. The main reason is that EMs are typically more reliant on external financing, largely because they have limited domestic financial resources and, oftentimes, large fiscal or current account deficits (e.g., Brazil, Chile, Mexico, India and Türkiye).
However, we believe major EM policymakers have learnt valuable lessons from the past—the Latin American debt crisis, the Asian financial crisis and even 2013’s short-lived Taper Tantrum episode. Of prominence, many EMs have, over time, instituted more orthodox macroeconomic policies, namely: adopting inflation-targeting; moving to flexible exchange rates; and, maintaining fairly prudent fiscal stances (Mexico, Indonesia and Philippines) or, in some cases, implementing fiscal rules (Brazil, Chile and Peru). Moreover, numerous EMs (Brazil, India, South Africa and Thailand) have built large stocks of foreign exchange reserves, which insure against volatile capital flows and have strengthened their banking systems in terms of supervision and regulation, credit lending standards and capitalization (Brazil, Mexico and Thailand).
It’s worth noting that many EM central banks (Brazil, Mexico, Peru and South Africa) began tightening monetary policy well before the U.S. Federal Reserve. Lest we forget, Banco Central do Brasil started hiking in March 2021 and has subsequently lifted its key Selic target rate 1,175 bps to 13.75%. Similarly, the Banco de México also got into the act quite early on in June 2021, while Peru joined in August and Colombia in October. The decision by Latam central banks to get a head start reflects the fact that they were much more concerned about inflation becoming unhinged earlier than their G7 counterparts. However, we also suspect that Latam central bankers wanted to pre-empt the possibility of another Taper Tantrum episode, which necessitated staying well ahead of developed markets’ central banks given their relatively weaker external finances (large current account deficits and gross external debt). Getting in front of the Fed has helped shield many Latam currencies from the soaring greenback.
Nonetheless, the picture across the major EM world is not uniform, a fact that is exemplified by the rather bizarre/idiosyncratic policy choices being pursued in Türkiye. Its central bank (CBRT) continued to defy conventional inflation-fighting norms and cut its key one-week repo rate 100 bps to 12.0% last week even though headline consumer prices climbed a staggering 80% y/y in August (likely much higher in reality for the average Turkish citizen). All told, the CBRT has lowered its policy rate by 700 bps since August 2021, which explains why the lira has plunged from 8.5/US dollar in August 2021 to 18.5 currently, in turn exacerbating inflation. However, we do not see the CBRT reversing course (as it has in the past) anytime soon, given President Recep Tayyip Erdoğan’s unorthodox view on monetary policy, specifically that “a higher interest rate causes, rather than curbs, inflation”. It’s clear that President Erdoğan wants to get the economy rolling well ahead of the next general election scheduled for mid-2023. Thus, it seems reasonable to believe that he will continue to place pressure on the CBRT and, in tandem, push domestic banks to extend more credit.
Key Takeaway: Thanks to the use of more orthodox economic policies, even during the course of the pandemic, many of the world’s major EMs look better equipped to cope with the increasingly challenging global economic backdrop. However, we suggest keeping a closer eye on those EMs that have benefitted immensely from the commodity boom (Brazil, Chile, Indonesia, South Africa, etc.) as a sharp reversal in prices would undoubtedly increase pressure on their respective economies.