Developing nations in new economic crisis

This originates from the monetary policies of developed countries and the behaviour of their investment funds.

Several developing countries are now being engulfed in new economic crises as their currency and stock markets are experiencing sharp falls, and the end is not yet in sight. The ‘sell-off’ in emerging economies has also spilled over to the American and European stock markets, thus causing global turmoil. Countries whose currencies were affected in the second half of January include Argentina, Turkey, South Africa, Russia, Brazil and Chile. A hike in interest rates by Turkey and South Africa has so far failed to stem the depreciation of their currencies. An America market analyst termed it an ‘emerging market flu’ and several global media reports tend to focus on weaknesses in individual developing countries.

However, the broad sell off is a general response to the ‘tapering’ of purchase of bonds by the US Federal Reserve, which marks the slowdown of its easy-money policy that has been pumping many hundreds of billions of dollars into the banking system. On Jan. 29, the Federal Reserve reduced its monthly asset purchase by another 10 billion dollars to 65 billion dollars, following the 10 billion reduction in December. It gave a new boost to the weakening of emerging market currencies. A lot of the Federal Reserve money pumping had earlier been taken up by American investors and placed in emerging economies as they searched for higher yield.

With the tapering expected to raise yields in the US, money is flowing out from bonds and stocks in the emerging economies, putting pressure on their currencies. The capital flows have reversed direction.

Boom-bust cycle

The current “emerging markets sell-off” thus cannot be explained by ad hoc events. It is a predictable and even inevitable part of a boom-bust cycle in capital flows to and from the developing countries, which originates from the monetary policies of developed countries and the behaviour of their investment funds.

This cycle, which has been very destabilising to the developing economies, has been facilitated by the deregulation of financial markets and the liberalisation of capital flows which in the past had been carefully regulated. This prompted massive and increasing bouts of speculative international flows by Western investment funds, motivated by the search for higher yields. Emerging economies, having higher economic growth and interest rates, attracted the investors.

Yilmaz Akyuz, chief economist at South Centre, analysed the most recent boom-bust cycles in his paper Waving or Drowning? A boom of private capital flows to developing countries began in the early years of the 2000s but came to an end with the flight to safety triggered by the Lehman collapse in September 2008. However, the flows recovered quickly. By 2010-12, net flows to Asia and Latin America exceeded the peaks reached before the crisis. This recovery was largely caused by the easy-money policies and near zero interest rates in the US and Europe.

In the US, the Federal Reserve pumped 85 billion dollars a month into the banking system by buying bonds. It was hoped the banks would lend this to businesses to generate recovery, but in fact investors placed much of the funds in the Western stock markets and in bonds and shares in developing countries. The surge in capital inflows led to a strong recovery in currency, equity and bond markets of major developing countries. Some of these countries welcomed the new capital inflows and the boom in asset prices.

But others were upset that the inflows caused their currencies to appreciate (thus making their exports less competitive) and that the ultra-easy monetary policies of developed countries were part of a “currency war” to make the latter more competitive. In 2013, the capital inflows into developing countries weakened due to the European crisis and the prospect of the Federal Reserve “tapering”. This weakening took place at a bad time - just as many of the emerging economies saw their current account deficits widen. Thus, their need for foreign capital increased just as inflows became weaker and unstable.

In May-June 2013 there was a preview of the current sell-off when the Federal Reserve announced it could soon start “tapering”. This led to sudden sharp currency falls including in India and Indonesia. However, the Federal Reserve postponed the taper, but in December it finally announced a reduction of its monthly bond purchase from 85 to 75 billion dollars, with more to come.