THE world is still rushing to figure out what sort of crisis is now confronting the emerging world. one thing most people seem to agree on is that this is not a replay of the late 1990s. Then governments had fixed exchange-rate pegs and large debts denominated in foreign currencies. Capital outflows threatened their pegs, and abandoning the pegs threatened an explosion in the size of the debt burden in domestic currency terms. That raised solvency concerns, which accelerated the rush for the exits. As meagre foreign-exchange reserves dwindled governments were forced to depreciate and some accepted IMF assistance to avoid damaging defaults.
Economies now in the crosshairs face different worries. Emerging market public-debt loads are generally manageable and denominated in local currencies. Neither capital outflows or depreciation threaten government solvency. Directly, anyway.
The potential threat this time around is more interesting, but also almost certainly less severe. The place to begin discussing the crisis is in the early 2000s. Emerging economies soured on fixed exchange rates after the nastiness of the 1990s, but most remained committed interveners in the foreign-exchange market. In the early 2000s, as capital began rushing back to the developing world many of them dipped into markets to slow appreciation. In the process they accumulated substantial foreign-exchange reserves (while also giving a boost to domestic exporters). From the beginning of 2000 to the beginning of 2008 global foreign-exchange reserves rose from just under $2 trillion to more than $7 trillion. The emerging world accounted for most of the rise; its reserve holdings soared from less than $1 trillion to $4.7 trillion.
Research by economists Philip Lane and Jay Shambaugh concludes that reserve growth is the single biggest source of improvement in emerging-market exposure to foreign currencies. Governments owe less foreign-currency debt. And equity financing grew in importance after the Asian crisis. But private firms still have quite a lot of debt denominated in foreign currencies.
Indebted private firms lack direct access to reserve hoards. Yet a government can use reserves to help when trouble hits, provided private debt burdens are not too large. A recent paper by Matthieu Bussière, Gong Cheng, Menzie Chinn, and Noëmie Lisack examines emerging-market performance during the crisis of 2008. They find that the ratio of reserves to short-term debt strongly predicted GDP growth during the global downturn. When trouble hit, governments were able to deploy their reserves to help private firms. They sold some in markets to resist depreciation as capital flew to safety. And they also were able to back firms and banks with emergency lending. Today India seems to have deployed another means of using sovereign reserves to support private firms, by lending dollars to its oil interests so that they need not sell rupees and buy dollars on their own.
But it's important to note that these interventions move crisis dynamics ever-so-slightly toward what economies faced in the late 1990s. Direct foreign-exchange market intervention depletes reserves; between April and July Indian reserves dropped 5% while Indonesia’s hoard shrank 14%. If reserves are exhausted, affected economies lose the ability to ease their currencies' declines or support domestic firms. Depending on what the perceived harm of that loss of control is, markets could seize on shrinking reserves as an excuse to pounce. The fact that governments aren't defending a particular rate is important; it means that currencies are less overvalued than they might be and it removes the line in the sand that seems to drive panic. But floating doesn't provide a complete defence from harm. Meanwhile, use of reserves to support private firms could be trouble if economic conditions deteriorate. In that case bad bank loans, say, would end up on sovereign balance sheets, and the governments would once again find themselves holding a big chunk of foreign-currency denominated debt.
The critical question, then, is whether existing reserves are big enough to handle the struggling economies' short-term obligations. Things are dicier than they could be. Mr Bussière et al note that not all emerging market economies rebuilt reserves after the crisis. India’s, for example, never recovered their pre-crisis peak. Meanwhile, short-term foreign-currency debt has grown sharply in many economies since 2008.
But on the whole, there is good reason to be optimistic. In 1997, Indonesia's short-term debt was roughly 188% of its reserve holdings. As of last year, by contrast, the figure was around 40%. In India the number in 2012 was closer to 30%. Ratios are higher in South Africa and Turkey but remain well short of the Asian crisis danger zone, at least as of last year.
Balance-sheet effects aside, the biggest worry is that depreciation will disrupt monetary policy. A large depreciation raises import costs which can feed through to inflation. As financing grows tighter interest rates may rise; ominously, the yield on 10-year Turkish debt recently topped that on similar duration Greek bonds. Central banks may exacerbate the rises by raising short-term interest rates, either to encourage foreign capital to stay put or to head off looming inflation. After a hefty 50-basis-point rise today Indonesia has raised its policy rate 125 basis points since May, even as GDP growth has weakened.
Recent financial-market gyrations clearly have emerging-market leaders biting their nails. But the figures suggest they should be able to cope with the knock-on effects of depreciation. And the depreciations themselves will give a boost to their export sectors, albeit on a lag. The biggest risk looks to be a policy error—like excessive monetary tightening—that tanks the economy and deals a big blow to domestic firms and banks. But having been so battered by markets in past decades, emerging-economy policy-makers may be unable to stare them down this time around, even if they have the fuel in the tank to do so.
The Economist_ Reserve judgment.pdf
