Debate: Gavyn Davies et al. on Emerging Market Turbulence: Wednesday Focus: March 19, 2014

Gavyn Davies ran a little debate over at his place in the FT:

Gavyn Davies: A debate on emerging market turbulence: “I have asked three distinguished international economists… Maurice Obstfeld (University of California, Berkeley), Alan M. Taylor (UC, Davis) and Dominic Wilson (Co-Head of Global Economics, Goldman Sachs)….

Since the text turned out to be fairly lengthy, I would like to offer here a summary of the main points which emerged….

Sudden Stop or Credit Crunch?: I have previously argued that the current EM crisis is likely to be characterised by a domestic credit crunch in many economies, rather than a “sudden stop” in capital inflows, similar to that which occurred in the 1990s…. Everyone agreed that most of the EMs are far better placed to withstand capital outflows than they were… flexibility of exchange rates… structural advances…. [But] there was a clear recognition from the panel that there has been a very worrying build up in leverage and domestic credit in the EMs since 2008, and that this could cause major disruptions…. AMT presented data which showed large rises in domestic leverage in China, South Africa, Turkey, some Baltic countries, Ukraine, Colombia, Brazil and India – a familiar cast list…. There was considerable concern about the possible balance sheet mismatches that might be revealed in such circumstances, since previous crises have always uncovered problems in unexpected places…..

Hidden External Debt Problems: MO said that he remembered “sitting in an IMF lunch about 10 years ago, thinking hard about ‘What will cause the next crisis?’ We were basically at sea…. We could spin scenarios but lacked the detailed information about financial linkages to know if any of our stories were plausible…. No-one at the table suggested US sub prime lending.” He did however predict that “the real threat, as in every past big financial crisis, is leverage”…. Optimism for Many EMs: There was a lot of optimism that many EMs would navigate the Fed’s exit well, because their policy responses would be appropriate. But there was concern about whether withdrawals of liquidity would put pressure on the available “lender of last resort” facilities…. The “Correct” Policy Response: I asked whether the “correct” policy response by EMs to the developing situation should be more like an IMF-type package involving fiscal and monetary tightening, and structural reform (“Fischer style”), or a World Bank-type package involving liquidity support… there was clearly some sympathy with Stiglitz….

China: AMT summed up the panel’s view very well when he said that China’s domestic leverage was a serious problem “but China has so much command/control that maybe they could “brute force” their way through with interventions, reserves etc.” DW added that it will “remain a difficult balancing act between discouraging risky lending practices without prompting a more rapid credit disruption” and concluded that “the task of rebalancing the economy is likely to be a long one”….

Summary: I summarised the panel’s views as follows: Without making any specific investment recommendations, I would conclude from the debate that it is too early to get back into EM assets, though there would probably be some exceptions, in countries where the policy response appears to be best calibrated to the problems faced. The panel seems to think that China will engage in a very prolonged credit work-out, without major acute crises, while some other EMs might face crises, even though their external balance sheet problems seem much better than in the 1990s. That seems to be a difficult environment in which to make money from general long exposures to EM asset classes.

I would just note that the stakes are very large. It has always been the case that success at equitable growth on a world scale hinges on creating a world economy in which EMs can and do catch up to the industrial core. And it is even more so now: the chances that the U.S. or Western Europe will be an engine of growth for the world economy over the next five years are rather small–full recovery in them, if it happens, is more likely to be the result of expanding emerging market demand for their exports pulling their economies up.

Given the possible large gearing between post-industrial core and EM periphery–today’s version of “when London catches cold, Buenos Aires catches pneumonia–both the ECB’s and the Federal Reserve’s strong inclination to focus on internals seems to me likely to prove unwise.