When a Nobel economics Laureate, a Harvard finance professor and an emerging market guru take the same dim view of developing economies, you’d expect the investment community to sit up and take notice. The combined intellect of Paul Krugman, Carmen Reinhart and Mark Mobius is pretty formidable after all.
But investors have done much more than prick up their ears. They have also voted with their feet. As the chorus of voices predicting an emerging market crisis has grown louder, bonds issued by governments and companies based in developing economies have spiralled lower. Year-to-date, the JPMorgan GBI-EM Index of local currency emerging bonds is down some 5 per cent1.
Still, it’s not the first time investors have been confronted with dire warnings about a credit and currency crunch in emerging markets. The same occurred during the "taper tantrum" of 2013, when the US Federal Reserve first signalled its intent to rein back quantitative easing.
The bears turned out to be wrong then. They are also mistaken now. And on several counts.
The bears turned out to be wrong then. They're also mistaken now.
The sceptics' chief concern is the damage higher US interest rates and a strong dollar – the consequences of the Fed’s monetary tightening – could do to the finances of emerging nations.
Many developing countries are reliant on foreign investment to fund persistently high current account deficits. When US rates and the dollar head north, these economies find it harder to service their debts; they also struggle to prevent international investors from shifting capital elsewhere.
Inflation can be a headache, too. By increasing the cost of imports, a stronger dollar usually gives rise to inflationary pressures, making life uncomfortable for central banks.
This year’s sell-offs in Argentina’s peso and Turkey’s lira – countries with some of the largest current account deficits in emerging markets – speak to the naysayers’ fears. The peso and lira are down 32 per cent and 21 per cent respectively since the start of 20182.
Making a bad situation worse, the pessimists say, is that corporate finances are barely any healthier. Since the US turned on the monetary taps in 2009, companies in the emerging world have taken full advantage of low interest rates, increasing their borrowing as percentage of GDP from about 80 per cent in 2013 to 101 per cent at the start of 2018.
With the bulk of those loans and bonds denominated in US dollars, the Fed’s tightening of the monetary reins threatens to make it harder for the private sector to pay back its debts, too.