This summer’s market turmoil was a serious jolt to emerging markets, particularly commodity exporters and those countries with strong trade and financial ties to China. Fortunately, there are good reasons for comfort that the tail risks facing these countries do not rise to the level of the Asia financial crisis or the Great Recession. After early missteps, China’s policymakers have been more assured in recent weeks in signaling their commitment to near term stability and support for growth. Financial distress in emerging markets, the most serious channel for contagion, has yet to materialize. Moreover, bolstered by high reserve levels, more flexible and competitive exchange rates (see chart) and in some cases better policies, emerging market buffers against contagion have been strengthened.
In my monthly, released yesterday, I ask whether, in the event of crisis, policymakers are up to the task of an aggressive and coordinated response. I have several concerns:
- The scale of financial imbalances is large. Corporate emerging-market debt now stands at $18 trillion, or close to 75 percent of gross domestic product (GDP), and leverage has soared. The Great Recession reminded us that interconnectedness—even more than the size of financial institutions—can be a recipe for crisis. The lack of transparency regarding China’s economic policies and relationships matters as well. China’s importance for financial markets and supply chains is not well understood, and a hard landing in China, renewed crisis in Europe, or even the anticipated normalization of U.S. monetary policy could cause real distress in countries as diverse as Brazil, Turkey, and Korea.
- Weak global growth environment limits the scope for policymakers to respond to a demand shortfall. A few years ago, the judgment that emerging markets had come out of the Great Recession with strong fiscal and monetary positions—“policy space”—provided optimism that these markets could outgrow the industrial world and would be able to adopt expansionary cyclical policies in the face of a global shock. That optimism is now dashed, as many countries’ strong fiscal positions have been wasted and market reforms rejected.
- The global fire station is poorly equipped to deal with future blazes. Over the past two decades, official resources to address crises have not kept pace with the rapid growth of financial markets. The IMF has seen its resources bolstered, but a recent reform package that would have strengthened its governance and ensured broad support for its crisis resolution efforts remains stuck in the U.S. Congress. A vote by the International Monetary Fund (IMF) Board later this month to include the Chinese currency in its currency basket (the SDR) may make passage of the bill more difficult, suggesting that there is a narrow window of a few weeks for the reform package to catch a ride on must-pass legislation.
- Growing fiscal constraints in the major creditor countries mean that coming up with the necessary official sector finance will pose an increasing challenge when facing protracted, large-scale financial crises. In Greece in 2012 and Ukraine this year, it was the inadequacy of official funding and the resultant financing gaps, as much as anything else, that dictated the timing and extent of private debt restructurings.
- Political pressures on governments are also limiting their ability to respond actively with financing and the other tools at their disposal—including regulatory measures and through the bully pulpit—to address market crises. In Europe, rising populism on both the left and the right, and bailout fatigue after years of crisis in the periphery, has weakened governments and reduced support for bailouts. In the United States, the Dodd-Frank Act and other postcrisis legislation and regulation limit the capacity of the Federal Reserve and Treasury to provide emergency support. In contrast, during the 1994 Mexican bailout and the 1997 Asian financial crisis, the creative use of U.S. economic power—including moral suasion on banks to participate in restructurings—played a central role in stabilizing markets. In recent years, the Group of Twenty (G20) has been the focus of policy coordination, but whether that group could find common cause as it did in 2008 remains a question.
Although a severe global financial crisis remains a tail risk and not the base case, governments should be prepared to respond. A strengthened and reenergized G20, an IMF with adequate resources and improved governance, and governments willing to act aggressively to deal with potential contagion are all needed to ensure that the downside scenario, if it occurs, does not become a major crisis.
FIGURE 1. EMERGING MARKET CURRENCY VALUATION
Source: Goldman Sachs, Investment Strategy Group, Investment Management Division © 2015