Revisiting original sin

By R.A. | LONDON

WHEN the first whispers of Fed "tapering" set off a storm in emerging markets last year, there were lots of reasons to think a repeat of the emerging-market crises of the 1990s was not in the offing. Fewer emerging economies had hard currency pegs and more of them had large defensive reserve hoards. But the most important difference was in the borrowing: sovereigns had done less of it, and more of what they owed was denominated in their own currencies. That prevented a turn in market sentiment from setting off a dangerous downward spiral, in which loss of faith in currency valuations shook confidence in governments' ability to service their debt, which fed back into downward pressure on currencies.

This week's Free exchange column looks at recent developments in emerging financial markets and assesses whether the developing world is inching back toward old vulnerabilities.

Governments in emerging markets have mostly remained disciplined...the share of emerging-market government debt issued in foreign markets has continued to drop, from 12% in 2008 to 8% last year. Private firms, however, have been more likely to succumb to temptation.

Emerging-market companies have begun issuing foreign-currency-denominated debt with gusto: $1.3 trillion of it was outstanding in 2013, up from $597 billion in 2009, according to Nomura, a Japanese bank. As a result, foreign borrowing as a share of all emerging-economy borrowing has been climbing. Banks are leading the way. Since late 2008 the share of debt issued by financial firms abroad has risen steeply, from 15% to 22%, the IMF says...

Even so, foreign-currency exposure remains relatively limited. But that may be less of a saving grace than it used to be:

The financial maturation that allowed emerging economies to do more of their borrowing locally has necessarily raised foreign participation in local-government bond markets. In some economies, the share of local-market government debt owned by foreigners has more than doubled since 2009.

Investors continue to do a poor job discriminating between developing markets based on the underlying health of their economy. And stampeding capital can still apply uncomfortable financial pressure, as the market wobbles of the past year revealed. Falling currencies may hurt exposed firms’ balance-sheets, thereby weakening investment and the outlook for growth. An abrupt growth slowdown looks preferable to the crises of the late 1990s. But it is no Eden.

There are actually two issues at play here. One is that private-sector exposure to currency shifts could prove tricky to manage even if an emerging economy's net external position looks pretty healthy. That is because private firms can't easily draw on sovereign resources when they get into trouble. If a falling currency creates problems for firms, then the government can step in, by orchestrating bail-outs funded by local-currency denominated debt or by drawing on reserves to help manage the decline of the currency. But those aren't the most comfortable interventions for a state to make. They create moral hazard, they are often politically difficult to deploy outside of an outright crisis environment, and they weaken the sovereign's financial position. Which is to say that emerging-market governments that want to reduce the risk of crisis may need to keep a close eye on private balance sheets and should be prepared to use regulatory measures to discourage risky behaviour. The lessons drawn from the 1990s crises—that limiting sovereign debt, borrowing in the local currency, floating the currency, and running small current-account deficits—are not sufficient to avoid pain given a shift in global capital flows. Though pain, as the piece points out, need not mean a full-blown crisis.

The second point is a broader one, which applies to many developed economies as well as the emerging world: that in a highly financialised global economy, free movement of capital may inevitably constrain domestic macro policy. Tapping into global capital markets generates large benefits, especially for those emerging economies that would struggle to generate enough investment if forced to rely on domestic savers alone. But there are costs to openness, as well. This is the point of the Helene Rey paper delivered at Jackson Hole last year. The central banks looking after the world's reserve currencies set the music that plays in global capital markets. The cost of participating in those markets is that you dance along with their tune and grin and bear it when the Fed chair plays something you don't particularly like.

One interesting question is whether more aggressive use of macroprudential tools can deliver the benefits of openness while minimising many of the costs. Another is what will happen to the global financial system in future if the answer is no.