The Fed’s QE unwinding and declining commodity prices are driving emerging market adjustment. Both are a gradual process. The last wave of emerging market currency depreciation is another step in the adjustment process.
The vulnerable economies are the ones with current account deficits and/or declining terms of trade. Brazil, India, South Africa and Turkey fall into that category. The only way to prevent a full-blown crisis is to raise interest rates above the expected inflation rate. India and Indonesia have done a good job in this regard.
The magnitude of currency depreciation must reflect the past high inflation due to hot money inflows or rising commodity prices. Undershooting is possible if the rising real interest rate exposes problems in banking asset quality.
Contagion is pronounced in the short term. But, the current emerging market challenge is driven by currency overvaluation, not foreign currency debt or overcapacity. Competitive devaluation is not a major force like in 1997-98. Contagion should mainly be a financial market phenomenon and would blow away quickly. Hence, each emerging market under pressure can decide its own fate.
These markets have avoided a major crisis so far. This can continue if they raise interest rates to stabilize inflation and deemphasize growth. That seems to be the consensus among emerging market policymakers.
Some emerging economies may experience a full-blown crisis for two related reasons. They are unwilling to raise interest rates despite their currency tumbling, and their banking system cannot withstand a positive real interest rate. Therefore, their currencies will experience maxi-devaluation repeatedly, which would trigger hyperinflation.
1997 vs. Now
Two differences set apart emerging markets in 1997 and now. Then, their banks borrowed short-term dollar debt and lent out as local currency loans for investment. When the liquidity tide reversed, their banks suffered currency losses and went bankrupt. The banking crisis crushed domestic demand. They had to devalue as much as needed to find export markets. As everyone was in the same shape, competitive devaluation pushed their currencies to extremely low levels.
Emerging economies have not borrowed that much in foreign currency this time. The main source of imbalance or froth came from hot money inflows driving up foreign exchange reserves and local currency supply. The latter led to inflation and negative real interest rates. Current account deficits have occurred in some economies due to negative real interest rates inflating domestic demand. This dynamic was amplified by rising commodity prices. Its impact is similar to hot money.
One major implication is limited pressure for competitive devaluation this time. Only China has enormous capacity formation. Others have not. As long as China does not devalue, which I believe, others will not come under much pressure for competitive devaluation.
Another implication is that a banking crisis is less likely than in 1997. Foreigners are taking the currency risk this time. The banking crisis could still occur if credit quality is vulnerable to rising real interest rates. That would be on individual basis, not an emerging market-wide problem.
Some emerging economies may go into crisis this time. For example, if they continue to emphasis growth over financial stability by keeping real interest rates negative, they will experience a vicious cycle of persistent currency devaluation and inflation. If their banks did not do a good job in controlling credit quality, a receding liquidity tide may lead to a banking crisis.
How Much to Devalue?
In the absence of competitive devaluation, the required devaluation is roughly in line with inflation since 2008. For example, India’s nominal GDP has been growing around 15 percent, 8 to 9 percentage points above the real growth rate. The cumulative excessive inflation above the United States’ level is over 30 percent. That is how much the Indian rupee has depreciated.
There are two factors that may drive the currency below that. First, the negative real interest rate led to too much demand. The adjustment requires belt tightening in the future to pay it back. The persistent current account deficit, for example, needs to become a surplus. As the troubled emerging economies are not big in manufacturing, they could not increase exports quickly and, therefore, must decrease imports to achieve a current account surplus. That requires both higher real interest rates and lower exchange rates than normal, at least for a period of time.
The wild card is banking stability. During a period of negative real interest rates, the quality of bank loans tends to decline. In particular, asset bubbles can deflate as real interest rates rise. The banks are often stuck with worthless collateral. The economies that have experienced surging property prices are quite vulnerable.
Currency depreciation or devaluation is not a big economic shock per se. A banking crisis is. When a banking crisis hits, the currency is quite unpredictable. As monetary policy needs to loosen up to ease the pressure on the banking system, the currency may decline dramatically, similar to what occurred to Southeast Asian economies in 1997.
The pressure on emerging economies has been on since the Fed signaled the unwinding of its QE in June. While emerging market currencies have gyrated, their banks have withstood the pressure. This is quite impressive and a better performance than I expected. Maybe this is due to the slow pace of the Fed easing.
The amount of hot money flowing into emerging markets since 2008 could be over US$ 3 trillion. It has led to huge, excessive credit creation. When surging asset prices and rapid credit growth go together, a banking crisis is likely. Many emerging economies experienced the phenomenon. It is inevitable that some will have banking crises.
*Read the entire article at Caixin.