September 14, 2018
Emerging market (EM) economies have recently come under pressure from international investors, with many EM currencies—including the Turkish lira and Argentine peso—sharply depreciating against the dollar and prices on EM financial assets experiencing steepdeclines. This broad trend has affected all EMs to varying degrees, but it would be a mistake to think of EMs in monolithic terms. Correctly identifying the source of EM vulnerability is important for assessing the potential for broader contagion as well as the appropriate policy response. Mitigating EM vulnerability is clearly in the Unites States’ self-interest: on the 10-year anniversary of the Lehman Brothers collapse, and the 20-year anniversary of an officially engineered bailout of a massive U.S. hedge fund, it’s worth recalling former Federal Reserve Chairman Alan Greenspan’s assertion: “It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.”
Q1: What is behind turbulence in emerging markets?
A1: There are two categories of factors contributing to the current turbulence in EMs. The first, so-called “idiosyncratic” factors, are specific to a particular country and often the result of economic policy choices. The EM economies currently facing the most acute market pressure pursued economic policies—for instance, excessive credit growth or government spending—that led to large macroeconomic “imbalances.” These imbalances, when they manifest as large fiscal or trade deficits, need to be financed, often in loans denominated in dollars. However, once investors grow skeptical of a country’s ability to repay, they withhold financing, leading to a “sudden stop.” The sudden stop almost always results in a sharp decline in economic activity, which is precisely what is happening in Argentina and Turkey.
Political risk is another “idiosyncratic” factor that can undermine investor confidence. High levels of political risk, where investors are uncertain about the direction of policy, can also leave economies vulnerable to tighter financing conditions, thereby slowing economic activity. Even economies that do not have large macro imbalances but have uncertain policy outlooks may be vulnerable to changes in investor sentiment. Here, Mexico and Brazil, among others, come to mind.
But these country-specific factors don’t adequately explain the broader EM sell-off. Rather, country-specific vulnerabilities are coming to light precisely because a more systematic shift is underway, namely the tightening of monetary policy in the United States. Consistent with its mandate to promote price stability, the Federal Reserve is increasing interest rates as the U.S. economy gains steam in order to avoid inflation. Interest rate hikes increase the return on U.S. assets, making them more attractive to investors and strengthening the dollar. But as the dollar strengthens, it becomes more expensive to repay dollar-denominated loans, which is another reason investors have intensified their scrutiny of EMs.
Q2: What other factors might be contributing to EM weakness?
A2: Market participants have long understood that the U.S. economy would pick up speed in the near-term on the back of large tax cuts and that the Fed would likely raise rates in response. This raises the question of whether there might be other sources of recent EM volatility. Rising protectionism and escalating trade tensions between the United States and various trading partners have weighed on certain segments of the market since the 2016 presidential election (see, for example, the Mexican peso’s performance). But until recently, investors largely dismissed the possibility that the Trump administration would make good on threats to withdraw the United States from trade agreements or launch a full-blown trade war with China. While an agreement avoiding the worst-case outcome of U.S. withdrawal from NAFTA appears to be at hand, the United States seems prepared to escalate the trade war with China by imposing tariffs on another $200 billion of Chinese imports (possibly followed by tariffs on another $267 billion, which would effectively shut down all bilateral trade).
New tariffs on Chinese imports will increase prices for U.S. manufacturers and consumers, add to inflationary pressures, and possibly cause the Fed to raise rates even faster. While the prospect of additional U.S. rate hikes is bad for EMs, there may be a more fundamental reason investors are starting to react, which is that the escalating trade war appears to be unmasking some of China’s own domestic vulnerabilities. China’s currency and financial markets have already been under pressure from the trade war, but it now appears that investors are starting to internalize the implications of slower Chinese growth for EMs. Consider that in the decade since the global financial crisis, China has been the single largest contributor to global economic growth. Much of that growth has been dependent on commodity imports, a large portion of which comes from EMs. To the extent the trade war with the United States weighs on Chinese growth and exacerbates China’s own vulnerabilities (think financial sector fragility), this will have a major negative impact on the global economy and EMs in particular.
There are several potential shocks beyond a sharp China slowdown that could weigh on the outlook and turn a vulnerable environment into a full-blown EM crisis. These include U.S. withdrawal from NAFTA or the WTO, disruption related to a “hard” Brexit, or a re-emergence of stress in the euro area. These potential risks are just that, and while most EMs are under some market stress, so far at least, this episode falls short of a systemic crisis.
Q3: How might the United States be affected?
A3: This brings us to Chairman Greenspan’s 1998 quote that the United States isn’t immune to economic conditions in the rest of the world. To be sure, countries experiencing weaker growth will import less, including from the United States. U.S. exports totaled $2.3 trillion last year (roughly 12 percent of U.S. GDP), and foreign markets are critical to the success of numerous U.S. business sectors, such as agriculture and technology. In addition to weaker demand from economies under strain, a stronger dollar, other things equal, will make U.S. exports more expensive. At a time when the United States is focused on lowering its trade deficit, lower growth in EMs and a loss in competitiveness due to dollar strength will work in the opposite direction.
Financial spillover from EMs is another potential channel for contagion. Chairman Greenspan’s statement came around the same time the Federal Reserve Bank of New York brokered a bailout of New York-based hedge fund Long-Term Capital Management, which suffered huge losses in bets that went south in part due to turmoil in overseas financial markets; that intervention was justified on the basis that losses incurred by investors in the hedge fund, which included a number of U.S. financial institutions, could pose a risk to financial stability in the United States. That experience, not to mention the 10-year anniversary of the Lehman Brothers bankruptcy and the global fallout that ensured, is a vibrant reminder that financial markets are globally connected. To be sure, financial supervision and capital buffers have been significantly upgraded since 2008; however, a decade of record-low interest rates has led to a surge in borrowing, raising the prospect that a correction may be coming.
Q4: How should the United States respond?
A4: Some observers have asked whether the Federal Reserve might adjust the pace of interest rate hikes in light of EM vulnerabilities. With economic growth running above the unemployment rate, it’s unlikely the Fed will refrain from further interest rate increases, at least in the near-term. That doesn’t mean a change in the official sector’s approach isn’t warranted. Heightened surveillance is a must, including coordination among regulators and government agencies that have key roles in international economic policy. Given that the “baseline” scenario entails further U.S. interest rate hikes and a stronger dollar, we know many EMs will be vulnerable as a result. It’s worth thinking about how to encourage “first best” responses by these countries. Countries should be encouraged to work with the International Monetary Fund (IMF), where financial assistance is predicated on corrective policies and any loan is approved by a Board where the United States is the largest shareholder. Less-good options might bring alternative sources of money—say, direct support from China or other lenders—absent corrective policies, but the terms of that lending may not be in the best interest of the recipient country—or ultimately of the United States.
At the very least, the United States should appreciate that it is the world’s largest economy, the single largest source and recipient of foreign investment, and issuer of the global reserve currency, the dollar. Actions taken by the United States will have spillover effects. And sometimes those spillover effects might spill back onto our shores.
Stephanie Segal is deputy director of and a senior fellow with the Simon Chair in Political Economy at the Center for Strategic and International Studies (CSIS) in Washington. D.C. James Smyth and Matthew Sullivan, CSIS Simon Chair research interns, contributed to this Critical Questions piece.
Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).