The Coming Emerging Markets Storm
(from the Banker's Digest: http://service.tabf.org.tw/TTB/Article/Detail?aID=415)
By David Stinson (Project Research Fellow of TABF)
Several months into the pandemic, the health implications of the COVID-19 coronavirus are becoming clearer. The economics still remains in flux, as almost every variable of interest across the world is seeing massive changes. It’s difficult to even find a model for this type of crisis.
It’s not a classic recession or depression caused within the banking or financial sector. Although quarantines and shutdown orders have collapsed economic activity at breathtaking speed, policy makers in the US have also acted with commensurate speed, keen to avoid a repeat of 2008. Whereas in that case the response involved great efforts to clean up balance sheets, in this case mainstream banks can tolerate a deterioration in credit quality in order to extend a lifeline to struggling businesses.
The source of the problem is clearly in the real economy. So then would one compare it to the supply-side oil shocks of the 1970’s? In this case oil supply hasn’t been affected, and prices are may soon go all the way into negative territory, so that isn’t a useful model either. The crisis began on the supply side, and it may have stayed that way for the rest of the world if the virus had remained contained in China – but it has long since manifested in consumer demand as well.
Some economists have even taken a wider view and re-examined pandemics and wars across history. In simple terms, pandemics make labor scarce, and therefore more valuable. The impact of COVID-19 is unlikely to be large enough to affect the labor supply directly. This perspective is mostly irrelevant to a world with modern banking and globalized trade.
Rather than any of these examples, the best point of reference might a somewhat less severe crisis that nonetheless shaped Asia’s financial development for decades to come: the financial crisis in 1997. As the present crisis drags on, access to international exchange and various contagion effects could similarly become key factors. The geography may be different this time around, and the overall extent of damage greater, but the key point remains that emerging markets will bear the brunt of the financial impact.
Approximately US$ 100 billion of portfolio investment has left emerging markets since January. This outflow, occurring mostly in March, is equivalent to that during the entire year of 2008. The research firm Capital Economics expects emerging market activity to decline in 2020, for the first time since records were kept in 1951. Countries with less-developed health and other infrastructure are certain to bear the brunt of the impact from COVID-19.
This is certainly not to say that the impact on the developed world will be light either. Whole industries will be created and destroyed. The effects have occurred so quickly that they are not yet being picked up in official statistics, but the numbers that have been released as of early April paint a dire picture. Unemployment claims totaled 16.8 million from March 15 to April 4, obliterating a previous weekly record of 695,000 sets almost forty years ago, three times in a row. The St. Louis Branch of the US Fed projects that the US unemployment rate could peak at 32%, compared to a peak of 25% during the Great Depression.
All of this is a natural, straightforward consequence of stay-at-home orders. It is still possible that contagion effects could occur, despite the vigilance of US policy-makers. The energy sector will suffer from widespread bankruptcies, and it remains unknown what months of shutdown could do to the real estate market and mortgages.
The US, however, has an important advantage over almost every other country in the world, ensuring that it should be able to keep the economic impacts from spinning completely out of control: the enduring reserve status of the US dollar. All concerns about debt have now been thrown out of the window; US public debt is likely to soon exceed its World War II record of 112% of GDP. Congress swiftly approved a US$ 2 trillion stimulus package, and the Fed’s balance sheet has expanded $1.5 million, completely undoing its modest efforts at re-entrenchment from early 2018 to July 2019. Furthermore, in a break from decades of practice, it is now purchasing local government debt.
These measures could eventually create longer-term pressure for an alternative to the dollar, but for the moment it is still viewed as a safe haven. It has surged, just as it did as a short-term reaction to the 2008 financial crisis. Meanwhile, Europe has in some ways handled the economics of the situation better than the US, using wage subsidies to prevent job losses. There are however already signs that the pandemic is exacerbating existing divisions between EU members on fiscal policy.
It’s all About the US Dollars
The most important signals to watch now the ones that could be amplified or have other complex behavior – and most of these go through emerging markets in some way. One of these, as already mentioned, is commodities. It’s so expensive to turn off some operational wells that producers will accept wholesale losses before taking their product off the market. (Saudi Arabia’s unexpected decision not to cut production did not fall into this category and was more political). Such price swings can devastate certain resource-dependent countries, like Nigeria, Angola, Indonesia, Iraq, and Algeria.
The main problem with commodities is not their direct impact, but what the current situation says about overall consumer and business demand. Exports are one of the two main ways that peripheral economies can obtain foreign exchange; the other is outside investment. A number of countries, including Turkey and Argentina (which have already faced crises), South Africa (recently downgraded), Chile, and Mexico have large dollar-denominated debts compared to their forex reserves, and the unfolding “sudden stop” scenario, exacerbated by the global trade environment, is calling into question their robustness. Taiwan, for its part, has a strong net positive forex position.
Just as during the emerging market crises of the 1990’s, here again we see the stratification of national currencies in a way that may not entirely reflect underlying economic conditions. Countries affected by the Asian Financial Crisis were encouraged to raise their interest rates to discourage capital flight, instead of lowering them, as any core economy would do. Being on the periphery makes weaker countries vulnerable to any sort of investor herding behavior.
One mechanism that has been designed in response to a situation like this is liquidity swap arrangements. The US Federal Reserve has set up such arrangements with Brazil, Korea, and Mexico among emerging economies. Through this practice, foreign central banks can borrow dollars and lend them out to their local banks while providing their own currency as collateral, allowing dollars to be distributed where they are actually used. This is not intended a bailout but rather intended to prevent the US dollar from floating too high. For that reason, the selection of countries is apparently based on factors like size and connectedness to the US economy, in addition to overall confidence in their financial systems.
The swap arrangement still hasn’t been enough to prevent currency depreciation in Mexico and Brazil, but it should serve to limit downside risks.
The potential scope of unstable dynamics doesn’t end with just monetary policy. The same supply-side risks that were originally feared are still around, and may become more severe as the crisis rolls through Asia. Most worryingly, farmers in India and elsewhere have been forced to dump produce due to logistical difficulties, creating food security concerns.
One short-term result of the current situation is that China likely will become both more powerful and isolated. The experience is reinforcing the Maoist tendencies within its political system, and also reviving domestic anti-foreigner (and even racist) sentiment. Internationally, it will tend to become more powerful by default. Its economy seems to be on a path to recovery, for the moment at least, while much of the world remains shut down.
The pandemic also seems to be driving Europe closer to the American attitude towards China, which recent developments including the Hong Kong protests and Xinjiang situation failed to do. The UK had previously sought to stake a position independent from the US on the politicized question of Huawei networks, but after its Prime Minister Boris Johnson announced his COVID-19 diagnosis, the administration expressed its fury with China. A government source leaked that it would be “back to the diplomatic drawing board after this.” China’s “mask diplomacy” appears to have failed in the European Union after several countries found the equipment faulty.
Meanwhile, in countries with weaker political institutions, the crisis is likely to promote authoritarianism and even state failure. On March 30, Hungary’s parliament gave the Prime Minister Orbán nearly complete powers, with no time limit. In Brazil, where the federal government has been dragging its feet, drug gangs have stepped in to fill in the governance gap and enforce lockdowns.
There may still be some dwindling reasons to hope that the after-effects of the COVID-19 virus will be short-lived. Shorter-term shocks have a way of reverberating and changing form, however. Factors like currencies, supply chains, and public health systems will determine whether the downturn will take a ‘V’ shape, with a steep downturn and correspondingly steep return, or a worse form such as a ‘U’ shape, with a prolonged struggle back to normalcy.