There has been a fair bit of pessimism about the fate of emerging market economies this year. At Project Syndicate, Kermal Derviş writes that, with the Federal Reserve expected to begin tapering off its quantitative easing programs, "the emergent market bears are ascendant once again." In gauging whether countries like Brazil, India, Indonesia, South Africa, and Turkey are in trouble, Davis urges us to pay a little less attention to public deficits and look more at private sector balance sheets.
To be sure, the weakest-looking emerging countries have large current-account deficits and low net central-bank reserves after deducting short-term debt from gross reserves. But one could argue that if there is a capital-flow reversal, the exchange rate would depreciate, causing exports of goods and services to increase and imports to decline; the resulting current-account adjustment would quickly reduce the need for capital inflows. Given fiscal space and solid banks, a new equilibrium would quickly be established.
Unfortunately, the real vulnerability of some countries is rooted in private-sector balance sheets, with high leverage accumulating in both the household sector and among non-financial firms. Moreover, in many cases, the corporate sector, having grown accustomed to taking advantage of cheap funds from abroad to finance domestic activities, has significant foreign-currency exposure.
Where that is the case, steep currency depreciation would bring with it serious balance-sheet problems, which, if large enough, would undermine the banking sector, despite strong capital cushions. Banking-sector problems would, in turn, require state intervention, causing the public-debt burden to rise. In an extreme case, a “Spanish” scenario could unfold (though without the constraint of a fixed exchange rate, as in the eurozone).
It is this danger that sets a practical and political limit to flexible exchange rates. Some depreciation can be managed by most of the deficit countries; but a vicious circle could be triggered if the domestic currency loses too much value too quickly. Private-sector balance-sheet problems would weaken the financial sector, and the resulting pressure on public finances would compel austerity, thereby constraining consumer demand – and causing further damage to firms’ balance sheets.
To prevent such a crisis, therefore, the exchange rate has to be managed – and in a manner that depends on a country’s specific circumstances. Large net central-bank reserves can help ease the process. Otherwise, a significant rise in interest rates must be used to retain short-term capital and allow more gradual real-sector adjustment. Higher interest rates will of course lead to slower growth and lower employment, but such costs are likely to be smaller than those of a full-blown crisis.
Read Tailspin or Turbulence? here.
Filed under: india, Brazil, Brookings Institution, emerging markets, public debt, south africa, project syndicate, turkey, indonesia, argentina, Kemal Derviş, private sector balance sheets, current account deficits