The increasing damage the global financial crisis is inflicting on emerging markets has been getting a lot of attention lately (those are four separate links, for those with time on their hands), much of it very thoughtful. I would like to immodestly point out that my co-authors Simon and Peter were early to call this one (along with Nouriel Roubini, no doubt), in an op-ed in Forbes.com back on October 12.
That aside, it seems more and more likely that we are witnessing a repeat of 1997-98, just on a grander scale. Credit default swaps on Russian sovereign debt are trading at over 1,000 basis points, which essentially means that investors think the country is more likely to default than not – this just months after the high price of oil seemed to make Russia a dominant regional economic power, and just weeks after Russia was negotiating to lend money to Iceland (as of a couple days ago, it was still possible that Russia would participate in the IMF bailout of Iceland). Argentina, as Simon pointed out earlier, has the honor of being the first country to expropriate private property under the cover of the financial crisis. The Economist published a chart showing CDS spreads on sovereign debt across Eastern Europe showing that Ukraine, the Baltics, Hungary, Romania, and Bulgaria are all at risk. (Many of those spreads are already much higher than in the chart: Ukraine at 2617 bp, Russia at 1038, Turkey at 775, the Baltics between 650 and 1000.) Hungary in particular is showing eerie echoes of 1997-98, as the government takes emergency steps, including increasing interests rates by three full percentage points, to combat speculators betting that the currency will fall – a battle that few countries were able to win a decade ago.
I won’t go into more details; you can read the news yourself. Perhaps the starkest sign of the emerging markets crisis is what Bjorn Malmquist, an Icelandic reporter, said to Planet Money: “Everybody is wondering when the IMF is going to come and help us” – this after widespread speculation that the IMF had become just one among many sources of money in times of crisis.
For those wondering what is going on: The basic dynamic is that nervous lenders are refusing to roll over loans to countries seen at risk of default (or companies in those countries), which can become self-fulfilling. Even where governments built up foreign currency reserves to prevent precisely this problem, like in Russia, they have been undermined by private sectors that gorged themselves on foreign debt. It’s similar to the crisis of confidence that hit banks in the wealthy countries, with the added twist of floating currencies. When creditors fear that, say, Hungary will default on its foreign debts, demand for forints dries up, because the only place you can invest forints is in Hungary; when demand dries up, the forint loses value, which means that from the perspective of Hungary, all of those debts get bigger and even harder to pay off. As a side effect, this means that currency speculators can make money by betting on which country will come under pressure next, as happened in serial fashion in 1997-98. Which country comes under attack at a given time can therefore be somewhat arbitrary and not necessarily correlated with the underlying solvency of the banking sector or the government.
As Simon and Peter said in their op-ed, the risk is that the global economy degenerates into financial war, where countries look out for their own economies at the expense of others. Within the developed world, coordination has been pretty good, after a rocky start. However, Brad Setser points to one disturbing thing. In granting unlimited swap lines with central banks in the UK, the Eurozone, Switzerland, and Japan, did the Federal Reserve unwittingly create a split between haves and have-nots in the global economy? As G7 become more attractive places to put your money, emerging markets become relatively less attractive, exacerbating the problem.
Emerging market countries can probably be protected through sufficient application of financial force, in the form of loans from the IMF, the ECB, or other sovereign governments (just like shoveling cash into a bank perceived as risky can make it seem less risky). But the IMF doesn’t have enough money for the scale of the problem, and bailing out emerging markets hasn’t made it to the top of the G7 agenda (understandably). Establishing the mechanisms to combat such crises in the future will need to be one topic for the international summits that will occur during and after this crisis.
One more thought: Americans may ask why we should care, given all of our domestic problems. In my previous post I pointed to the case of Pakistan, where financial crisis may create even more political instability. More broadly, though, I think it’s a certainty that we will be blamed for any economic misery that occurs in the wake of this crisis, since the conventional wisdom is that we exported it to the rest of the world. That’s one more thing our national reputation needs.