Since the start of the decade, in a latter-day gold rush, investors have flocked to fast-growing emerging markets. The likes of Brazil and Indonesia were a way to dodge the perils of the eurozone, and lock in some attractive returns. Like all such parties, this one was too good to last. What began with a wave of sudden retreats last summer has turned into a steady exodus. In the week to last Wednesday outflows from emerging market stocks jumped to $6.3bn, the largest weekly withdrawal in nearly three years.
From Mumbai to Pretoria, central banks have tried to halt this rush for the exit by raising interest rates. The most dramatic moment came in Turkey, where the monetary authorities more than doubled the weekly benchmark rate from 4.5 per cent to 10 per cent. Markets were unimpressed. After a few hours of euphoria, most emerging economy currencies resumed their slides.
Nor does the outlook appear much brighter. Asia and Latin America are being pulled down by two powerful forces, neither of which is expected to weaken. One is the rebalancing of China’s economy away from investment, which will continue to hit exports among commodity producers. The other is the tightening of global liquidity, a consequence of the US Federal Reserve’s tapering of its quantitative easing programme. The more investors expect US yields to rise, the less appealing exotic emerging market assets appear.
The question now is whether the turmoil in emerging markets will spread to mature economies. There are a few worrying straws in the wind. Global shares came close to registering their worst January since 2009. Safe assets such as US Treasuries and German Bunds are suddenly back in vogue. The appetite for risk that investors have shown since the summer appears to be waning.
While worrying, this should not escalate into a full-blown contagion from emerging economies to rich countries. A note by Goldman Sachs, the investment bank, argues convincingly that the linkages between the two blocks are still too weak. Take, for example, trade. Turmoil in Latin America and Asia will weaken the demand for goods and services from the eurozone, US and Japan, threatening their incipient recovery. However, exports to emerging markets are still a tiny proportion of the combined national income in these countries. While a slowdown in emerging markets would undoubtedly hurt some companies, most should find it manageable.
In theory, the risk of financial contagion is more severe. But while the exposure of banks from high-income countries to emerging markets is relatively high, it is not overly concentrated. It is also possible that the weakest economies in the west – for example in the eurozone periphery – could end up benefiting from the stampede out of the new world by offering a safer investment opportunity.
One of the main lessons from the financial crisis, however, is that once market panics start it is hard to predict where they will stop. The brittleness of the recovery in developed countries reinforces the case for prudence. True, the US continues to hum along, after expanding at an annualised rate of 3.2 per cent in the final three months of last year. Britain and Japan also appear to be back on the march. But the eurozone is still stuck in low gear, as unemployment remains high amid growing fears of deflation.
These vulnerabilities risk being exposed as the Fed continues to taper. This week the US central bank reduced its monthly asset purchases by another $10bn. The process towards the normalisation of interest rates has only started but its consequences will reverberate across the world. This is why Raghuram Rajan, governor of the Reserve Bank of India, was right to call for greater co-operation among the global monetary authorities.
What exactly the US should do to appease the concerns of emerging economies is unclear. But Janet Yellen – who takes over from Ben Bernanke as the Fed’s chairwoman this weekend – should initiate a running dialogue with her colleagues from both the developing and the developed world to mitigate the negative consequences of tapering. To that end, she can call on the outstanding international experience of Stanley Fischer, her vice-chairman.
Of course, this does not excuse the governments of emerging countries from their own responsibilities. The best way to ensure that foreign investors remain interested – and invested – in those countries is to implement the reforms needed to maintain economic dynamism.