There has been a lot of hand wringing lately about emerging markets. Worries are two-fold: economic problems and stock/bond market problems. Today I’m going to write about the first, tomorrow the second.
Even when I was in school, there was a well-understood, coherent, all-encompassing theory of how a closed one-country system works economically. There’s nothing like that, even today, for a multi-country system with open trade, differing political philosophies and involving countries at various states of economic development.
I guess I’m saying that what follows is highly simplified, although I think it still gets across what the basic forces at play are.
an emerging country
Suppose the citizens of an emerging country, or the government for that matter, want to obtain goods made by another country. Let’s also say the seller won’t accept the buyer’s local currency but wants to be paid either in its own currency or in some global standard, like dollars, or euros or renminbi.
The buyer has several choices. It can:
–barter with the other country, avoiding the forex issue,
–sell domestic goods in international markets, obtain foreign currency that way and use it to buy the foreign goods,
–use foreign currency it has previously piled up somewhere,
–sell domestic assets, like farmland or mineral rights, to foreigners or
–borrow the foreign currency it needs.
If the country routinely generates enough foreign exchange to meet its needs (think: oil exporters), there’s no problem. It can buy all the foreign goods it wants. But that’s not normally the case. Emerging countries routinely run trade deficits (that is, they buy more stuff from foreigners than foreigners buy from them). To make up the difference, they borrow any extra foreign currency they require. [an aside: it’s also possible that the government of the country we’re talking about runs a budget deficit, meaning it spends more than it takes in. That’s also a problem, but it’s not what we’re talking about here.)
In economic boom times, investors tend not to worry too much about how and when they’re going to be repaid. (In fact, a generation ago international banks deliberately made loans to emerging countries that they knew could not be repaid. The banks figured they’d collect big fees when the loans were restructured. The possibility of default never entered their heads.)
In leaner times, investors look more carefully. They make a (crucial) distinction between borrowing that pays for factories that will manufacture goods for local use or export, and borrowing that pays for purchases that produce no economic return (think: flat screen TVs, gold jewelry or military gear). Building factories that will generate foreign exchange in a year or two is ok. Borrowing to buy consumer items isn’t.
Lenders may initially be willing to make loans that are payable in local currency. As/when the country begins to have a chronic trade deficit, lenders are no longer willing to do so They shift to loans repayable in dollars…, which makes the foreign currency problem worse.
In cases where lenders see the probability getting their money back declining, new lending dries up. The local currency begins to weaken. The government has to raise interest rates–this supports the local currency and cuts into demand for foreign goods by slowing overall economic activity. This is all toxic stuff politically. Sometimes (think: Argentina) local governments find any form of austerity to be impossible.
In my experience locals sense the beginning of a downward spiral long before the international investing community does. Capital flight begins. This makes the situation worse.
loose worldwide money policy
One of the side effects of qualitative easing in the US + Abenomics in Japan + Chinese efforts to promote the renminbi as a world currency has been to flood the world with money. A lot of that has found its way into sketchy emerging countries that are economically unstable and on the verge of a currency crisis. It appears many yield-chasing investors were unaware of the risks they were taking. The presence of relatively high yields was all they saw. Others were playing the greater-fool theory, figuring they could sell before the music stopped.
When the Fed began to talk about an end to tapering, the latter group knew the game was up and began not only to cease new lending to,but also to extract their money from, what has since become known as the Fragile Five. That has led to weakening currencies, lower securities prices and a higher cost of lending in these countries.