Emerging Markets Face a Natural Correction

Moody's

  • Shifting global monetary conditions are battering emerging market currencies.
  • This is arguably a natural correction, triggered by the reversal of global capital flows.
  • On the whole, emerging economies seem better-prepared for this than in past cycles.
  • Policy flexibility and a commitment to stabilize real exchange rates can prevent a new financial crisis.

Emerging markets are suffering the consequences from a reversal of the conditions that previously caused many of their currencies to appreciate. Foreign exchange markets have been in turmoil this week as worried investors sold off emerging market currencies and other financial assets in response to the start of U.S. Fed tapering.

A reversal in capital flows

Since the beginning of the year, emerging market currencies have weakened significantly, particularly in Argentina, Brazil, India, Russia and Turkey.

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Except for Argentina, these countries were also the main beneficiaries of portfolio investment flows and easy credit in the past few years, as developed-world central banks boosted liquidity following the 2009 recession. These large capital flows caused real exchange rates to rise in emerging markets. The resulting currency misalignment led to the rapid growth of imports and the emergence of large fiscal or external imbalances, or both.

Although each economy has its own set of risks, emerging market currencies have nearly all experienced the result of the global flight to quality in recent days. Countries most affected are those with significant external imbalances, but even those running current account surpluses or small deficits have been hit. As expected, the larger the imbalance, the higher the probability of a speculative attack against a country's currency.

The turmoil has raised self-fulfilling fears of contagion, as occurred in the Asian financial crisis of 1997-1998. Already, the South African rand has come under pressure, as have currencies in Eastern Europe. Yet we believe emerging markets will avoid a repeat of the Asian crisis, for several reasons.

The arsenal of reserves

Emerging markets have changed since the late 1990s. Drawing on the cash that flowed into emerging markets via bond sales and commodity revenues in the past few years, central banks in the larger emerging markets accumulated record high reserves. This has allowed policymakers in Brazil, India, Turkey and South Africa to intervene during recent episodes of currency pressure, either by selling dollars or raising interest rates. This policy flexibility can help counteract the effects of market overreaction.

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A second stabilizing factor is the switch to flexible exchange rate regimes in many countries. Instead of being forced to use foreign reserves to defend fixed currency exchange rates, emerging market countries can allow currencies to adjust to more sustainable levels.

The crisis episodes of the 1990s marked the end of fixed and semi-fixed exchange rate regimes, starting with the Mexican peso crisis in 1995, Asia and Brazil in 1997-1998, and Argentina in 2001. Though the flexible system can autocorrect currency misalignments, policymakers have the option to carry out discretionary interventions to avoid huge currency swings and reduce the distortionary effects on financial and real variables.

Policy changes instituted during the 2009 recession to rein in imbalances are another important factor. Many emerging market countries employed a mix of structural changes and policy adjustments to keep imbalances at levels that are moderate and able to financed. High commodity prices also supported government budgets and external accounts.

Currency misalignment

The nature of the current wave of currency depreciation offers another important reason for believing that a financial crisis can be avoided. This appears to be a natural correction of misaligned currencies—not because of overvaluation due to artificially fixed exchange rates, as was the case in Thailand during the Asian financial crisis, but because major global central banks are unwinding the policies that generated excess global liquidity in past years.

The currency misalignments caused by quantitative easing among developed-world central banks explain the reduction in the current account surpluses of China and other Asia-Pacific economies, and the deterioration of the current accounts of Eastern European and Latin American countries in the years after the 2009 recession.

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As the Federal Reserve moves to unwind its monetary stimulus policies, interest rates will rise in the U.S., causing capital to flow back from emerging markets. The recent depreciation of emerging market currencies thus represents a natural correction. At present, most emerging markets maintain flexible exchange rate systems, so an automatic adjustment can take place, bringing currencies back to sustainable levels. This process will in turn correct external deficits and lead to the normalization of fiscal and monetary policies in emerging markets. Central banks will adjust interest rates and liquidity to levels consistent with the new global reality.

How central banks should respond

To be sure, the transition carries risks, because markets worry about policy uncertainty and the impact of higher interest rates on growth. Emerging market central banks should thus act to reduce uncertainty by setting attainable, growth-conducive policy targets that will dampen output volatility during periods of financial market turbulence.

Central banks should aim for a stable and competitive real exchange rate that promotes the efficient allocation of resources, improves the transparency of monetary policy, and strengthens confidence in the central bank's ability to conduct monetary policy effectively. This will reassure investors that the policy environment will support growth by strengthening the economy's overall competitiveness while increasing productivity, containing inflation, and stabilizing asset markets.

In sum, there is no reason to panic. Emerging markets are only suffering the hangover that comes naturally after a global liquidity party. To reassure markets and reduce policy uncertainty, central banks can respond by setting realistic policy targets that support growth while stabilizing inflation.


Alfredo Coutino is a Director at Moody's Analytics.


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