Satyajit Das: Fears grow of history repeating itself with a crisis in emerging markets

In the 1994 ‘Great Bond Massacre’, holders of US Treasury Bonds suffered losses of around $600bn

Battle-weary policy makers do not want to believe that an emerging-market crisis is possible. But there are striking resemblances to the 1990s. Then, loose monetary policies pursued by the US Federal Reserve and the Bank of Japan led to large capital inflows into emerging markets, especially Asia. In 1994, the Federal Reserve’s chairman, Alan Greenspan, withdrew liquidity, resulting in a doubling of US interest rates over 12 months.

In the 1994 “Great Bond Massacre”, holders of US Treasury bonds suffered losses of about $600bn. Trading losses led to the bankruptcy of Orange County in California, the effective closure of Kidder Peabody and failures of many investment funds. It triggered emerging-market crisis in Mexico and 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.

Many now fear a re-run, triggered by rapid capital outflows and a rising US dollar.

Weaknesses in the real economy and financial vulnerabilities will rapidly feed each other in a vicious cycle. The fundamental fragilities of emerging markets – the current-account deficits, inadequate investment returns and high debt levels – will prove problematic.

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 over-extended 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 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.

A weaker currency will affect prices of staples, food, cooking oil and gasoline. Subsidies to lower prices will weaken public finances.

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 the familiar emerging-market death spiral. This is overly optimistic. Structural changes may slow the onset of the crisis. But real economy and financial weaknesses mean the risks are high.

 The IMF’s capacity to assist is constrained because of concurrent crises, especially in Europe.

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

Since 2008, emerging markets have contributed about 60-70 per cent of global economic growth. A slowdown will rapidly affect developed economies. Demand for exports which have boosted economic activity will decrease. Earnings of multi-national 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 hit international banks.

Emerging markets have around $7.4trn (£4.6trn) in foreign-exchange reserves, invested primarily in US, Japanese, European and UK government securities. If emerging-market central banks sell 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 large losses to holders. It will also increase financial stress, affecting the fragile recovery in developed economies.

Emerging-market currency weakness is driving a rise in major currencies, such as the US dollar. This will erode improvements in cost structures and competitiveness engineered through currency devaluation by low interest rates and quantitative easing. 

Over time, the destabilising effect of national actions and complex policy cross current may accelerate the move to closed economies, damaging global growth prospects.

In reality, developed economies sought to export more than goods and services, shifting the burden of adjustment necessitated by the 2008 crisis on to emerging economies.

Like a drowning man grabbing another barely able to swim, the policies may ensure both drown together.

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