Volatility in world financial markets has increased substantially in recent months. The US economy is experiencing a sharp slowdown, maybe even a recession. In this context, the question is often asked whether emerging markets will slip into crisis. In our view, the answer is no, and here is why.
First, external solvency has improved substantially. Several years of current account surpluses and robust equity inflows have allowed emerging markets to clean up their balance sheets. Governments have been pre-paying external debt and accumulating substantial external assets at an unprecedented speed, leading to a noticeable improvement in creditworthiness. External solvency indicators are far superior to what they were during the 1990s and early 2000s. We estimate that emerging markets in the aggregate (defined as the 25 largest emerging economies) became a net external creditor in 2007 – and this has not been simply due to massive Chinese asset accumulation.
Second, external liquidity remains abundant. Emerging markets continue to run an aggregate current account surplus and net capital inflows will remain near record levels this year. Uncertainty about the outlook for the US economy and financial markets and continued strong growth in emerging markets will continue to attract foreign investor interest. A strong external liquidity position provides emerging markets with a considerable buffer against external shocks, whether in the form of declining exports or a drop in portfolio inflows.
Third, the global environment remains supportive. The US economy may be heading south, but commodity prices remain high by historical standards, especially energy and metals. Continued strong demand for commodities from emerging markets and especially China is likely to support commodity prices. Increasing energy prices have had a knock-on effect on soft commodities like corn and sugar used in biofuels. Similarly, the recent sharp decline in US interest rates will help support emerging market asset prices. Increased risk aversion in US financial markets has spilled over into emerging markets and pushed up spreads. But the sharp decline in US interest rates means that in many cases emerging market asset prices have increased and financing costs have declined. Finally, the global growth outlook remains respectable, even though the US economy may slow down considerably. With growth in emerging markets in many cases fuelled by domestic demand, these economies are today far less vulnerable to a decline in US growth than in the past. The fact that economic growth takes place in the context of much more balanced domestic and external positions provides emerging markets with flexibility to counteract the slowdown in external demand through domestic policy measures.
Fourth, improved macroeconomic policy regimes have made many emerging markets less sensitive to external demand conditions. Improved external solvency and liquidity mean that emerging markets are less dependent on capital inflows. This has also allowed them to overcome their “fear of floating” and to introduce more flexible exchange rate regimes. Sure, some countries have maintained somewhat inflexible exchange rate regimes (e.g. China, Russia, less so India), but their net external creditor position, often combined with capital account restrictions, sharply mitigates the risk of balance-of-payments or other financial crises. In the past, fixed exchange rate regimes combined with a substantial dependence on capital inflows, typically to finance current account deficits, led to currency crises when investors lost confidence in the country, forcing the authorities to respond with monetary tightening and slowdowns in domestic demand and economic growth. Today many emerging markets can respond to such a situation with a combination of exchange rate depreciation and interest rate cuts. Also, generally improved fiscal and government debt positions allow emerging markets to pursue counter-cyclical policies, or at least do not force them to run pro-cyclical (contractionary) policies in an environment of slowing growth. We are therefore quite optimistic about the EM growth outlook, even if the global environment were to deteriorate more than we currently expect.
Last but not least, many countries have put in place credible and sustainable macroeconomic policies. Sure, supportive international economic conditions have made it easier to pursue stability-oriented policies. But in the key emerging markets a consensus seems to have emerged in favour of sustainable policies aimed at lower inflation, external solvency and sustainable public debt dynamics. The desirability of low inflation, fiscal adjustment and external asset accumulation are now widely accepted. The Asian economies decided to buy “insurance” following the 1997 crisis. Mexico became more cautious after 1994-95 and Brazil after 2002. Some countries in Latin America continue to pursue policy mixes incompatible with long-run macroeconomic stability. But in the wider emerging markets universe economic populism is limited.
The major emerging markets are capable of withstanding even a severe external shock. Of course, not all emerging markets are in an equally solid position to confront an external shock. Some Eastern European countries are experiencing large current account deficits, strong domestic credit growth, equity and housing market appreciations and an overvalued exchange rate. This combination has often proven a dangerous mix. But the systemically important emerging markets like China, Brazil, Russia, India, Korea and Mexico are in a strong position to face down even a sharp deterioration in global economic conditions. Of course, the United States is still the 800-pound gorilla, but emerging market economies are stronger and more agile today when it comes to coping with a sneezing gorilla.