Emerging Markets: The World’s Star Pupils

Monday, September 24, 2018
Don Pollard
Carmen M. Reinhart

Minos A. Zombanakis Professor of the International Financial System, Harvard Kennedy School

Steven A. Tananbaum Senior Fellow for International Economics, Council on Foreign Relations

Ruchir Sharma

Head of Emerging Markets and Chief Global Strategist, Morgan Stanley Investment Management

Gillian Tett

U.S. Managing Editor, Financial Times

The second session of the Stephen C. Freidheim Symposium on Global Economics looks at how emerging markets (China, Brazil, India, Russia, etc.) have fared over the past decade, the extent to which reserve accumulation and flexible exchange rates have enabled them to manage shocks, and the question of current financial stability.

This symposium is presented by the Maurice R. Greenberg Center for Geoeconomic Studies and is made possible through the generous support of Council Board member Stephen C. Freidheim.

TETT: Well, good morning, everyone, and welcome to the second session, “Building Off BRICS: The Future of Emerging Markets.” My name is Gillian Tett. I’m the U.S. managing editor of the Financial Times.

And I should say congratulations to all of you who survived the U.N. traffic this morning—(laughter)—which gets worse and worse every year.

And one of the people who’s going to be at the U.N. today and speaking is President Mauricio Macri from Argentina, who I just had breakfast with. And in many ways he epitomizes what we’re here to discuss this morning because a couple of years ago Argentina was coming back into the fold, investors very excited about its prospects, so much so that it achieved the remarkable feat of selling a hundred-year bond. But, of course, in the last three months that excitement has largely unraveled. There’s been a new crisis. Argentina’s had to go back to the IMF. It’s still unclear what’s going to happen next. And in many ways this is a story that’s perhaps more extreme in Argentina, but epitomizes what we’re seeing in the emerging markets, because once again we’ve seen in the last few months turmoil erupt, and once again people are asking are the emerging markets actually reforming themselves onto a sustainable path or are we going back to the future towards a new range of—new wave of crises.

And we have a fabulous group of people to talk with us about this. Carmen Reinhart, Professor Reinhart, known to most of you, who is of Harvard Kennedy School and of course co-author of that famous book This Time Is Different, or maybe not so different. Next to her we have Brad Setser, who is from the Council on Foreign Relations, a fellow for international economics. And on my immediate right, your left, is Ruchir Sharma, who is head of emerging markets and chief global strategist at Morgan Stanley, and also an author and a great expert on India.

So, is it back to the future? Is it really this time different? Carmen, tell us, how do you assess the current stability of the emerging markets? Are you surprised by the latest outbreak of market turmoil around Argentina and Turkey?

REINHART: No. Actually, about a year ago I did write a piece called The Curious Case of the Missing Defaults, which is about a historical look at what happens typically when commodity prices decline, when capital flows withdraw. And just those two things alone usually give you a big pop in new defaults. The shoe that had not yet dropped at that time really was the impact of rising U.S. or international interest rates. So, you know, those three external factors played a big role in the boom in emerging markets—you know, low rates, high commodity prices, large inflows, above-average growth. That era has been gradually ratcheting down. Not all at once, but that’s where we are. So it would have been more surprising if they were doing great still at this stage.

TETT: Right. And before I turn to Brad, how much—how many defaults do you expect? I mean, wonderful title, The Curious Case of the Missing Defaults, but it also begs the question of, you know, when do those missing defaults actually appear?

(Pause.) (Laughter.)

Oh, I was actually directing it at you. But feel free to—

REINHART: You were doing it at me?

TETT: Yes. Feel free to hand it to Brad instead if you prefer.

REINHART: Oh, OK. So, all right, let’s take that in steps. OK.

So in the—among the low-income countries, we actually, I am almost certain, have had more credit events, more restructurings, than what we hear about in the press, because a lot of the low-income countries borrowed from China. This is very opaque lending. The terms are opaque. The amounts are opaque. And there have been several recorded restructurings already. So that stuff, those kinds of credit events, don’t get picked up so much in—because they are low-income countries, you know, former HIPCs and so on. So we’ve had already, I think, more defaults.

Now, the big ones, the big emerging markets, well, I have to say, of course, Argentina, Turkey have been in the headlines. But those are not the only sources of concern. Those cases are ones in which external debt is a big issue. But then you have other cases, like Brazil, where it’s internal debts that are a big issue. And time will tell whether these big ones will also, you know, have a new wave of credit events. Certainly, in the case of Argentina, it’s a narrow line that they’re walking.

TETT: Right. Brad, are you concerned about contagion? I mean, do you think we are back to 1997 or some of the other bouts of contagion we’ve seen in the past?

SETSER: I mean, my best guess is no, for the following reason. I think there are very clear, very obvious vulnerabilities in Argentina and Turkey. Why haven’t there been as many defaults? I think the simplest answer is that most big emerging market governments held more reserves than they had foreign currency debt, which created a level of balance-sheet resilience that they didn’t have in the past. Two countries that don’t really meet that now: Argentina, obviously; and then Turkey, which while the government has relatively limited foreign currency debts, the banks have a ton of foreign currency debts, so the aggregate balance sheet isn’t as strong. So that—the fact that Turkey and Argentina stand out so strongly on indicators of vulnerability compared to the other big emerging economies suggests there’s a little bit of a—of a firewall.

The other important factor—and I think this is a source of some greater uncertainty—is that in the past, at least in my interpretation of what drove the depth of the ’97 crisis—the first leg was driven by balance-sheet weaknesses, too many—too much external debt, too few reserves. And then the second leg was, you know, triggered in part by a commodity shock, a commodity price fall that in, you know, ’98 followed from the collapse in Asian demand. Right now oil prices are pretty high, which on one level makes it worse for Argentina and Turkey, but on another level makes it hard to see how you would get a second leg of transmission to the oil-exporting economies. And then when I sort of think about what could drive the next round of stress, what could make this more systemic, the obvious shock would be something out of China.

TETT: Right. Well, those are two great questions we’re going to come back to, both the question of China internal but also China’s role in lending to other countries, which of course has made the whole question of debt restructuring very interesting. But before we come back to that question, I’d like to ask you, Ruchir, two questions.

One is over the weekend I was with some of the current administration, along with Sebastian and others, and I asked them to what degree they felt the gyrations in the dollar and the rising U.S. interest rates were putting pressure on the emerging markets. You know, is this a problem made partly inside America? They said, of course, no, no, no, no, it’s not our fault, it’s all their fault, they have to hurry up and restructure themselves. Do you agree? Do you think this is a problem partly of America’s making?

SHARMA: Well, it’s easy to blame everything on America’s making in terms of what happens in the world today. But I think that what is it—(laughter)—you know, what is it really? Sort of if you look back at history, right, in terms of the facts, I think, like, it’s—to put some historical perspective on this, one, that the world is on a dollar standard, in that ever since we sort of got off the gold standard we’ve been on a dollar standard. What does that really mean? Two things, that—and this pattern has reoccurred all the time. Whenever you have a stronger dollar, you typically have contracting global liquidity, and that always leads to problems in some place of the world or the other. That is the history of the post-Bretton Woods world, is that concern.

The second thing, which I think is really underappreciated, is just how powerful the dollar is today. Which is that, you know, there’s been so much talk about American declinism and all these other things, et cetera, but in terms of the financial side American exceptionalism has never been this stark. And there are so many metrics the way that you can look at this. Look at the role of the dollar in the global system. Whether it’s a share of FX reserves, a share in international transactions, a share of global debt, the dollar’s role, if you take it all combined, has never been this powerful as it is today. That is one of those things which I think is extremely underappreciated. So what that does is that now even small moves in the dollar have a very large impact on the global economy, on global financial markets.

Now, what’s really interesting to me is that how we’ve sort of come full circle; that if you rewind back to last decade, the talk was exactly the opposite. The favorite term of the last decade was decoupling, BRICS, in terms of what this was going to be. All this stuff was being spoken about.

At the beginning of this decade, I—you know, like, I wrote a book basically arguing as to why this BRIC hype was completely overdone in terms of it was not going to—now we seem to have come to the other extreme. Oh, these emerging markets—

TETT: Well, it’s time for you to write a book saying back to the BRIC hype.

SHARMA: (Laughs.) But in terms of the fact that—now we are back to the old sort of—sort of lines, which is that emerging markets and, you know, that they are destined to sort of always fail and stuff like that. And the reality and the truth, as we know, always lies, you know, somewhere in the middle. Emerging markets, many of them—there are about two hundred countries in the world or so which are tracked. Out of these, only I think thirty-eight or thirty-nine are classified as developed markets. The balance are classified as emerging, and many of them for centuries have been emerging forever. Like—(laughter)—you know, like Brazil, Mexico, you know, in terms of if you look at their per capita income relative to the United States for the last hundred years, they’ve gone nowhere. When commodity prices go up, they all look good. When commodity prices go down, they all look bad in terms of how it is.

So I think we’re at that juncture now where we are back to a lot of pessimism about emerging markets. We are back to the late 1990s, which was about the last time we saw such American exceptionalism in the financial markets like we saw today—like we are seeing today. So on every single metric today American exceptionalism in the financial markets and the role of the dollar has never been stronger. And I think that’s what’s leading to all these stresses which are showing up in different parts of the world.

TETT: Well, that’s fascinating. I’m going to come back in a bit and talk about India, but I can see Carmen’s keen to come in.

REINHART: So I think one way to simply think about the sheer magnitude of the importance of the dollar issue is, you know, we think of Argentina’s great default in 2001. Argentina’s external debt in 2001, on the eve of default, was less than fifty percent of GDP, when the peso was one-on-one on the dollar. When the peso went also three-on-one on the dollar, external debt blew up to about 140 percent. So valuation effects are huge.

But I do want to take an issue with something Brad said. I completely agree, Brad, that there’s more differentiation and better management on the whole on the part of emerging markets. But I honestly think that we shouldn’t rule out contagion a la late 1990s, for the following reason. I think the markets are pricing in vulnerabilities in the currency, vulnerabilities in the case of Turkey in banking, but I don’t think they’re pricing a sovereign default in a big EM. And this is sort of like what happened with Russia. If you remember Russia before default, yeah, you know, you had—you had capital outflows from Russia, but once it defaulted it hit Brazil, it hit Mexico, and it hit Hong Kong, simply because those were liquid markets. So you get a lot of cross-market hedging and a lot of stuff even if they have pretty good fundamentals, say, in the case of Mexico.

TETT: So where would you think—if there was going to be a big emerging-market default which isn’t priced in yet, where would you see the prime candidate as being?

REINHART: The prime candidates, look, I love to quote Stan Fischer as saying, you know, when he was governor of the Bank of Israel, having a liquid market, a liquid debt market, is a mixed blessing because when you try to have portfolio adjustments that are quick and abrupt you don’t go to Bolivia because, you know, you don’t have much Bolivian debt. The price—you know, the—

TETT: So the—

REINHART: —the cost of that transaction would be enormous. You’d go to the more liquid markets, so places like Mexico, Brazil, Hong Kong, South Africa, which have deeper capital markets, which have deeper—currency markets are often hit hard in these episodes.

TETT: Brad, I could see you trying to jump in there.

SETSER: Yes. Two—

TETT: Do you want to defend yourself and tell us why there won’t be contagion?

SETSER: Well, I don’t like disagreeing too much with Carmen. (Laughter.)

TETT: Please go ahead. It creates more dynamic. (Laughter.)

SETSER: I do think, you know, one of the interesting dynamics of the past, let’s say, year and a half has been that we’ve discovered that U.S. policy shifts still matter for most of the world, and that when the U.S. chooses a looser fiscal policy, which implies a tighter monetary policy, it shouldn’t be terribly surprising that those emerging economies with strong financial links but weak trade links to the U.S. get into trouble. And so, in that sense, the fact that Turkey and Argentina led the charge shouldn’t at all be surprising.

I think, you know, in terms of events, I don’t think a sequence of countries getting into so much trouble that they either default or go to the IMF is my base case. But I can imagine sets of circumstances which could lead to that result.

The first thing, which probably isn’t priced in but is conceptually possible, isn’t a big sovereign default, but it’s a big Turkish bank entering into some kind of restructuring that is messier than expected. I think the baseline expectation is the Turkish government will come in and, if necessary, find enough dollar liquidity to avoid large losses for any cross-border dollar creditors. Right now Turkey doesn’t have the resources to do that on its own. It can manage the fiscal costs of a bailout, but it doesn’t have enough foreign currency reserves. And the politics of Turkey getting those reserves are complicated.

The second chain of events that I can imagine causing real systemic stress, setting China aside, start in Argentina. So Argentina loaded up on foreign currency debt. Macri’s government basically doubled the amount of bonds issued that Argentina had outstanding in three years. In the face of the currency shock, Argentina’s debt-to-GDP, the IMF says it’s going to go to seventy (percent) in their stress scenario, but their stress scenario is less stress than what we observe in the markets today. So if you kind of adjust for that, debt-to-GDP is eighty (percent). And Argentina’s solvency hinges on having access to a friendly lender, the IMF, that will provide cheap financing in periods of stress. If the IMF doesn’t want to play that role, I think Argentina would inevitably be on a path that would lead to default. And if Argentina defaults, I think then there becomes a question about Brazil’s resilience, noting what Carmen said, the high level of domestic debt, but also noting that Brazil still has more foreign currency than the government, Petrobras, and the big state banks have foreign currency debt. So the dynamics of transition would differ, but you could imagine that sequence. And if that sequence happens, then I think it’s something that would feel like a major systemic emerging market crisis.

TETT: Well, let’s turn, then, for a moment to the IMF. I mean, obviously, the IMF and Argentina are still in negotiations. There appears to be a lot of good will as far as Argentina is concerned towards—from the IMF towards Argentina, helped by the fact that, of course, President Trump seems very fond of President Macri. Do you think, though, that the IMF is willing or able to keep acting as sort of global nurse, as it were? Because, of course, the IMF itself is facing a big battle in the next year to try and replenish its resources, and there’s questions about whether the IMF has the ability or willingness to keep playing this role. Who would like to jump in on that?

SHARMA: Well, I think that, you know, I’ll answer that, but I just want to sort of, if you don’t mind, just finish one point here in terms of like this whole contagion bit and then, like, the IMF’s role here.

So my own sort of belief is this, that the Turkey and Argentina—you know, like, every crisis plays itself out somewhat similarly, but somewhat differently. And I think that, for me, like, the way that I see the world today is that the Argentina/Turkey episode is done; which is that what had to happen there I think has happened.

Issue is, like, can there be another leg to this? And I think it’s all down to one country, which is China. I think that if something happens in China, that is when you get the next leg down as far as this crisis is concerned. Apart from that, I think that the emerging markets will be able to sort of muddle their way through this entire thing. And the issue it that why China? Why is it that I’m worried about China more than any other country at this point in terms of if something happens?

Well,, as you well know, that most of the increase in global debt which has taken place over the last decade has been concentrated in one country, which is China. In fact, if you look at the increase in global debt across the world, I think more than half of it is just China in terms of what’s happened. And then the other increase in debt which has taken place has been of much smaller scale in countries like Turkey and possibly like a couple of other countries mentioned there. So I don’t see sort of the other countries being that vulnerable.

But in China’s case, there are two issues that they are dealing with currently, which is the fact that every time they have been—in the past, I mean, China has faced an issue, they have been able to ease policy quite aggressively. They’ve cut interest rates, pumped more money into the system, and off you go again. But that’s led to rising leverage over time.

The issue here is this today, which is that they’ve also followed a de facto currency peg with the U.S. dollar. And this is, for me, the most interesting part. For the first time that I can recall, Chinese interest rates and U.S. interest rates have converged. And as the U.S. keeps increasing interest rates, the incentive for capital flows keeps increasing even though they’ve been quite successful in maintaining capital controls as far as their economy is concerned.

But can China afford to increase interest rates when its economy is slowing down quite sharply just now? I think that it comes down to that. And I think they’ve drawn a line in the sand, which is seven-to-one on the exchange rate, which is what everyone’s watching now. If something were to happen to that exchange rate, I think that’s when you get the next leg and this becomes a contagion. In the absence of that, I don’t think there is enough vulnerability out there. Because remember one thing that—in terms of the whole point, that emerging markets for the past decade have been through a workout process.

And there’s one really easy way of looking at it. Since 2008, the U.S. stock market has more than doubled in value. In dollar terms today, emerging markets since 2008 are still below their 2007/2008 peak.

TETT: Wow.

SHARMA: So, you know, this has been a staggering period of underperformance.

And for me, I hate to say this, but as a market person I have to sort of distinguish here a bit, which is that it is typical at the end of a cycle for everybody to pile on on the pessimism, you know? As I said, in 2007/2008, everybody was optimistic on emerging markets. The same people today bashing emerging markets, you’d have to sort of calm them down in 2007/2008, BRICS and the irrelevance of America and how America was doomed to decline. And Lula’s favorite comment in 2009 still stays in my head, when he basically said this crisis was not black or brown, it is white in terms of it, in terms of, you know, what he said. And Gillian and I were talking about Brazil being in the crosshairs of the crisis.

So I think that this is typical behavior where we sort of pile on at the end, everything is negative, everything was positive in 2007/2008. It’s entirely possible that we get an entire leg down, but I would say the defining line for this is going to be China.

And this brings me back to the IMF point. Again, I was going back to like 2007. Do you know what the favorite articles used to be in 2007? On how the IMF is going out of business. Why? Because they said the IMF had virtually zero programs running anywhere in the world because no country in the world needed an IMF program in 2007. (Laughter.) No, you know, not one. You know why? Because of the two hundred countries in the world that we track, I think only about two of them for the first time in history recorded a negative GDP growth. I mean, the number was that low. And the two countries I think were Fiji, Afghanistan—basically, who cares, right? (Laughter.) So in terms of that’s what—that’s what happened.

TETT: Well, I think the people in Fiji care, yes. (Laughter.)

SETSER: Anyway—

SHARMA: So that’s what happened. And here we are today where we are back to the full circle. So that’s where I come out at, which is that now it’s—you know, like, contagion, yes, possible, but let’s focus why and where rather than just talk about it here.

TETT: Well, let’s talk about China, because—Carmen.

REINHART: But, but, but—whoa, whoa, whoa. (Laughter.) So you’re telling me that Argentina/Turkey issue, that’s done? That’s discounted?

SHARMA: For now. Yeah, discounted. That’s the point, yeah.

REINHART: No, no, no, no, I don’t think so. I don’t think you can equate currency crisis or banking crisis with default. Default—a Turkish default does mean—there are banking exposures. Notably, Spain, Italy, they’ve made loans to Turkey, to Turkish companies. So it doesn’t even have to be a sovereign default. If it’s a large-scale corporate default, that has repercussions for European banks much the same way that the crisis in Thailand and Indonesia and Malaysia had repercussions for Japanese banks.

TETT: So what about—what about China itself? I mean, how concerned are you two about China? Because, obviously, you know, people are watching very closely indeed this currency movement and the question of whether the Chinese will stick to the peg or not. It’s one of those geeky things, really, in the weeds of the financial market, so most people are ignoring. But it’s incredibly important what’s happening right now. How concerned are you about what’s happening in China?

SETSER: Well, I think you probably have three people onstage who spend a lot of time paying attention to, like, Chinese exchange rates. So I’m going to challenge that China is focused on seven to the dollar. I think it’s probably ninety-one against the CFETS or the exchange rate index that includes more currencies than the dollar. But whatever it is, it is a binary decision at this point about whether or not China is willing to maintain an exchange rate at that level. It’s a binary choice—

TETT: And, of course, if it doesn’t, we’re back in the situation where the markets fall and we get quite a nasty punch.

SETSER: I think we would all agree that if China does—if the yuan goes down by twenty percent, that is a major shock to everyone, particularly to emerging economies.

REINHART: Absolutely.

TETT: Carmen?

SETSER: But then can I just on the—

TETT: Yeah.

SETSER: Yeah. China has to make a decision, one, about whether they are willing to follow the Fed up, the point Ruchir made. China can stimulate, even if it is raising interest rates or not, cutting using fiscal policy tools. I think the central government has plenty of fiscal capacity. And in that sense, I think it is a choice.

And then I think China still has more than enough reserves that if it chose to, it could maintain the peg for a long period of time. So in that sense, I think it is a real choice about how China wants to respond to the—to the trade escalation that is coming.

REINHART: Right. Let me echo what Brad said. I think an exchange rate shock coming from China would have major repercussions for emerging markets. We got a little bit of a preview in the summer of 2015—

TETT: Exactly.

REINHART: —with a fairly minuscule depreciation by any standard and everybody’s exchange rate adjusted by more and it created quite a wave of turbulence across emerging markets. I stumbled literally upon—you know, I was giving a talk in Peru this summer and started looking at five-year correlations, growth correlations of China and Latin America. Since 1995, those five-year growth correlations are .75, these are simple—and so a very significant Chinese slowdown has big EM repercussions, to echo what Brad said.

TETT: Right. I mean, one of the fascinating things about China right now is not only is it in many ways the linchpin of trying to work out where the emerging market’s going to be going in terms of contagion, but it itself has been a big creditor to many impoverished countries and that’s hugely complicating the role of the IMF and others at the moment. How do you see that developing? I mean, do you feel you have much transparency on what’s happening, about whether there have or have not been defaults on the Chinese set to date?

REINHART: So I have, over the last few years, been trying from secondary sources and from press putting together data on this lending from China. It is huge. It is huge in dollar terms. It’s not enormous, but relative to these countries’ GDPs, they’re the big lender because they’re specializing—


REINHART: The problem from the IMF vantage point is that they know neither amounts involved nor the terms. The opaqueness surrounding these transactions is huge. So what kinds of problems does that create for the IMF? Number one, if you think that Guinea-Bissau or Angola—Angola’s external debt, Angola’s the leading borrower from China, has external debt of—I’m just making this up—of fifty percent. It might not be fifty percent, it might be seventy percent, it’s that much additional lending. That’s a big issue.

The second big issue is China is not part of the Paris Club, so the terms of restructuring, any kind of—you know, like, the highly indebted, low income—the HIPC, the poorest-country initiative that initiated the debt forgiveness. All of that was coordinated under the umbrella of Paris Club. China’s transactions are known to itself and the recipient.

TETT: Right. Well, that’s fascinating.

I’m going to field in—sorry—the members for questions in just a moment. Before I do that, I’d like to ask one other question which is this. I don’t see any sign that the Federal Reserve or the current administration is willing to do anything other than put America’s interest first in terms of setting interest rate policy. Do you see any sign that the Fed or others are paying attention to the emerging markets, given the primacy—

SETSER: Well, I mean, Donald Trump, in a way, has been an advocate for the emerging market position. I mean, he doesn’t want the Fed to tighten monetary policy. (Laughter.)

TETT: I don’t think he quite looks at it himself and sits around to save Argentina. But anyway, yes.

SHARMA: No, I don’t think so. I mean, I think that the Fed’s going to continue to sort of—and that’s the big risk as far as emerging markets are concerned, that, you know, on this dollar standard the Fed continues to sort of increase interest rates.

The only thing which I can say here is that, as I said, that the pessimism is deep and the extrapolation is high, which that does happen and that happens. So the way that I’m looking at the world today, like all the emerging markets, is basically, like, two scenarios. One, that if something happens in China, we get under the big leg down. But the second one, and I think that this is also interesting for me, is that rather than talking about all the problems in emerging markets, starting to look at which of those economies, which have suffered unnecessary collateral damage in this entire washout which is taking place currently. And I can find enough pockets in the world where growth rates are doing relatively well. They don’t have any sort of external vulnerability. They’ve worked out a lot of the problems. Like the one, you know, region I’ve always liked a lot is Eastern Europe. You’ve got economies like Poland. So I was saying that, for example, the fact that I just mentioned to you that there are only, what, thirty-nine countries classified as developed countries in the world. And the next one to join their ranks will be Poland is my forecast, basically.

And then you’ve got other countries in Southeast Asia, other places, even in Latin America, which are not that exposed to some of this, where you can argue that there’s basically been—there’s basically a lot of collateral damage. And you should start looking at these places where the collateral damage has taken place because of how well the U.S. has done and the gap is so wide between the U.S. and the rest of the world.

So there are two positions. I’ll still be—I’m still concerned that there’s one other shoe to drop and that’s got to do with China. On the other hand, you start sort of thinking of places which have suffered collateral damage, are not exposed to China, and you think that basically these places suffered collateral damage, rather than piling on and saying everything is going down the tube her.

SETSER: Can I just jump in? I mean, I think, undoubtedly, the U.S. will adopt its classic position on it with respect to monetary policy, which is that it is directed at domestic U.S. conditions and that the Fed will only adjust its policy when it is clear there’s negative repercussions that are echoing back to the U.S. That’s the way it’s been for a long time.

I think the unknown is the Trump administration’s policy towards the IMF.


SETSER: Trump doesn’t tend to make, best I can tell, policy decisions based on policy as much as on personality. He likes Macri, Macri gets a loan. He doesn’t like Erdogan, he really doesn’t like Erdogan, no way. Financial analysis of Argentina and Turkey has been a little bit secondary. If that continues, he may be more willing than might be expected to use the IMF as a bridge, which is what Argentina needs, given that Argentina’s debt sustainability, if you get stuck in old policy parameters, is fairly iffy. But conversely, Trump may be more inclined to use the IMF overtly as a tool of leverage to extract political concessions.

TETT: And do you think—going back to Carmen’s point about the Chinese lending and the way that that is, you know, challenging, complicating, sometimes even supplanting the role of the IMF—which I think is fascinating, I’d love to see your index of who is indebted to China and what’s happening there because I don’t think that’s publicly available, most of it. But do you think there’s any sense in the American administration now that they have to step up with the IMF, they have to show that they’re going to be nice to Argentina or anything else to try and counter the rising Chinese influence? I mean, this is a real, you know, big, geopolitical, great game.

SETSER: So we’re at the Council on Foreign Relations. I don’t think any one of my colleagues has yet detected the Chinese play for Argentina. I think if you want to do Chinese geopolitical expansionism, the more interesting case would be Turkey, given the geography. And then, obviously, the first case where the IMF’s relationship with China when the—when the IMF is going to be involved and the country hasn’t been terribly transparent and it doesn’t have the capacity to pay and it probably needs to restructure—well, it certainly needs to restructure its loans to China is going to Pakistan. And so I think that Pakistan is shaping up essentially as the test case for both the administration, the IMF and for China because China really hasn’t had to figure out how its debt will be handled and whether it will be just handled like everyone else’s or whether it’s going to be treated more specially. And I think that question will be resolved first in China. I’m sorry, Pakistan.

TETT: Yeah. Carmen, then others, the audience.

REINHART: One tiny note on the issue of the Federal Reserve. Look, the Federal Reserve, their mandate is a domestic mandate. It’s inflation, output gap, it’s a domestic concern. However, one thing that has been different is, number one, they’re providing much more forward guidance. So, you know, there are very few countries there that can be, you know, claim surprise to what the Fed has been doing. They’ve been doing things much more gradually and with much more forewarning.

So the issue of being caught off guard, you know, this is not the night—October 1979 spike in U.S. rates when Paul Volcker was, you know, trying to bring down inflation abruptly. Right? So in that regard, I think that has not reduced the influence of U.S. policy in emerging markets, but I think allowed for more preparation that this was coming.

TETT: Right. Well, that’s a good point.

Well, listen, I can see lots of hands waving already. A couple of quick pointers. Firstly, this is on the record. Secondly, please, if you ask a question, identify yourself. It’s not just courteous, it’s apparently compulsory here as well. And thirdly, keep your questions or comments short because I can already see a lot of hands.

Let’s start over here, I think the microphone behind you.

Q: Hi. Robyn Meredith, author of The Elephant and the Dragon.

Could we go from financial markets to the job market for a second?

And maybe, Carmen, given your past work on this you could comment.

I’d like to understand from you guys what you see the interplay is between emerging markets, particularly China, and the fact that, on the one hand, the U.S. has very low unemployment, but wage growth has been sort of low and slow. Could you talk about that phenomenon, how those may be interrelated and if we’re now seeing a sort of disturbance in the force of globalization? How is that likely to play out in U.S. wages?

REINHART: Well, for a while, part of the story on the slow wage growth was we had an unusually long and deep recession, characteristic of recessions following financial crises. That was—that was a big chunk of the story earlier on. The more surprising part has been of more recent vintage; that is, as we’ve marched towards full employment.

Look, there are all kinds of explanations. I’ll highlight a couple. One is we heard for a long time about lack of productivity growth. OK? We’ve also heard a lot about the role of globalization. Those have been, you know, two factors.

However, I think we—again, to pick on a very good point about extrapolating—I think at this conjuncture, it is dangerous or not dangerous, but it’s probably ill-advised to extrapolate, that because we have seen such abnormally sluggish wage growth in a period which had massive deflationary tendencies, not just for the U.S., but for the advanced economies as a whole—legacy of the crisis—I think it’s dangerous or risky to extrapolate that that is likely to continue.

My own expectations is that this is not a typical cycle, so don’t expect typical things, but that that below—that subpar performance may be—there may be a turning point around the corner there.

SHARMA: Yeah, I mean, I agree with that. Because, I mean, all the evidence in the developed world that we’re seeing so far across the developed world is that finally wages are beginning to increase, so that’s now happening across the developed world. Because the global unemployment, I mean, you know, this is one of those things, again, that we worry about something. That’s always, like, a rule for me, that what we worry about today will not be the worry five years from now.

So I think the one statistic to remember, that the global unemployment rate today in the developed world, if you look at it, is at close to the lowest levels in history, finally. So I think that finally now we’re seeing wage growth as a consequence of that.

TETT: The global unemployment rate.

SHARMA: Yeah, I mean, the global—

TETT: That’s fascinating. I haven’t—I mean, we all know about the U.S. unemployment, but we don’t often—

SHARMA: Yeah. Yeah, the global—yeah, so we keep track of this, of the global unemployment rate. It has to be for the developed market because emerging market unemployment rates are very hard to track. But the developed world global unemployment rate today is close to the lowest in history that we have going back 50 years.

TETT: Wow, fascinating.

Right, question over there and then we’ll go across there.

Q: Niso Abuaf, Pace University.

Is this working?

Perhaps this is the right time to connect this session with previous session.

TETT: We’re actually going to swap the microphone out. I think we—so if you could just—

Q: Niso Abuaf, Pace University.

TETT: Thank you.

Q: Perhaps this is the right time to connect this session with the previous session. In all likelihood, Turkey will have to restructure its foreign debt, which, as Professor Reinhart stated earlier, we can go down that path. That will mean significant—whether Turkey defaults or not, there would likely be a restructuring and that would be significant declines in the equity ratios of major European central—major European commercial banks, not only those in Italy and Spain, but probably also Germany. Could you just follow on that path a little bit maybe more? Thank you.

TETT: So are we facing new nasty banking surprises?

SETSER: I actually think that that question is much narrower. I think the real exposures are limited to a couple of European banks that have large Turkish subsidiaries who have, to some extent, funded those subsidiaries with cross-border loans.

The bulk of the stated exposure comes from, in the consolidated banking data, from the deposits in Turkey held by subsidiaries of European banks. And in a bad state of the world, those losses on that portion of the balance sheet—if you’re going to be, like, you know, Geithneresque, Paulsonesque, tough, whatever—the CEO of the BBBA or whatever bank can cut their losses by saying we’re going to not provide any additional cross-border credit. Write everything we’ve got down to zero, leave it to the Turkish government to manage all of the domestic deposits. It’s your bank, here are the keys.

My personal judgment is that the European banks, all the relevant European banks, are strong enough to make that decision and walk away from their subsidiaries. That still leaves the question of how Turkey would handle such a crisis. And that would be a real crisis.

One option would be to provide all of the recapitalization funds from the Turkish government’s balance sheet, in which case all the—most of the dollar credit would be protected. Another is to restructure a meaningful fraction of this. That would be Turkey’s choice when it comes to the equity capital.

There is a second question, which is that the Turkish banks writ large have about three-hundred-billion-plus in dollar liabilities and a lot of that is very short term, prone to runs, over half of it is domestic dollar deposits. And in order to provide dollar liquidity, independent of how you handle the equity, you could need additional liquidity support from someone.

So I think in the end of the day, I actually worry a little bit less about the direct exposure of the European banks and more about the absence of a real framework for managing the questions around the solvency and liquidity of the Turkish banking system writ large.

TETT: Right. Carmen wants to come in here and then we’ll go to a question there.

REINHART: So the orders of magnitude are not sort of late 1970s, early 1980s vintage with the exposure that U.S. banks at that time had to Latin America and other emerging markets. That’s not the scale.

However, I’d like to make a point of differentiation. It’s very different if a German bank has a problem at this conjuncture because of Turkish exposure than if an Italian bank has a Turkish problem at this conjuncture because the initial conditions in those two countries and those two banking systems are very different. You’re talking already about a case, in the case of Italy, which is already frail without incremental external shocks.

And so I think that that has to be factored into the equation, that this is not—it’s not going to have the same outcomes, whether it’s a Spanish bank or an Italian bank or a French bank. I think the most vulnerable spot is what it could possibly do to Italian banks.

TETT: And the usual moral is, if in doubt, worry about the Italians. (Laughter.)

Got a question, the gentleman with the red tie, and then the woman behind him.

Q: Eric Stein from Eaton Vance.

Ruchir, when you started, you talked about the problems of global liquidity in a strong-dollar environment. We’re in a strong-dollar environment now. And if you think back to February of 2016, we were also in a strong-dollar environment, a little different with commodity prices falling, but still EM, kind of risk off. Do you—and then we had the Shanghai Accord. You know, yes, there are issues with international cooperation today, but could you see a scenario—really for anyone on the panel—where the Trump administration, which certainly doesn’t want a stronger dollar, and EM countries, who also don’t want to see a stronger dollar, there could be more coordination to if not weaken the dollar, at least keep it from strengthening because it’s in multiple parties’ interests?

TETT: Well, we could have a new Boca Raton accord.

SHARMA: I mean, you know, that’s a very interesting thought. I mean, unfortunately, I just don’t know that as long as the Fed keeps increasing interest rates how you end up there. Because remember, like, a key principle of the Shanghai Accord was that the Fed sort of postponed. You know, like, basically went in a hole, you know, for a long period of time after that increase in December 2015.

I don’t see the scenario of that today. So the best hope for the dollar has to be that—I mean, the fact that, as some of our work shows, that it is today truly very expensive, so that, naturally, it sort of begins to peak. And also the fact that in Europe, you’ll find—you know, like, it’s sort of had this patchy economic recovery. We’re seeing some signs now that after the sort of weak economic data that in Europe economic activity is again beginning to pick up. So you’re hoping that, you know, that this lift comes from international.

But I don’t see the conditions for a Shanghai Accord just because of the fact that I don’t see the Fed focused on it because it—and the Fed maybe was different, you know, like, had much less confidence even in the U.S. economic recovery in February of 2016. Today I don’t see the Fed backing off, unless something dramatic happens to put them off that.

TETT: Right.

SHARMA: Yeah, so I think the chances of an accord like that happening are low apart from Trump’s state tweets which will continue about a strong dollar on, you know, every other week maybe, or something.

TETT: Well, I should have said Mar-a-Lago Accord, actually, rather than Boca Raton.

SHARMA: Exactly.

TETT: I’m a bit jet-lagged.

Carmen, what do you want to—what are your views on that?

REINHART: I actually agree. Think back to the Plaza Accord. The Plaza Accord in the ’80s involved the Japanese agreeing to allow for a stronger yen and the Germans—which still had the DM—doing the same. The Chinese are not going—or the Japanese—that seems very improbable, if not bordering on the miraculous. And, well, Germany has the euro. So it doesn’t matter that the surplus is big if it’s not—so the conditions are, in my view, not there for that kind of agreement.

TETT: Interesting.

We have a question over there. The lady with—thank you.

Q: Lyric Hale with EconVue in Chicago.

Although the Chinese have now established themselves in global debt markets, they have failed at establishing the yuan as a global currency in comparison to the U.S. dollar. And in fact, I think only 1 percent of world trade is conducted in the yuan.

At the same time, crypto assets are on the rise in emerging markets whose central banks have failed them. For example, I read a survey that 18 percent of people in Turkey now own bitcoin. So my question is, is this a new phenomenon? Is this something we should look at, and then bringing in emerging markets as a factor? And bringing the full circle around to China, China itself is also a major player in crypto assets and in the manufacture of equipment that’s required to create and maintain them. So that’s my question. Thank you very much.

TETT: Who would like to jump into bitcoin?


SHARMA: Sure. So, I mean, as you possibly know, that one of the big stories of this year has been the bust in cryptocurrencies, right? So basically, what a massive decline which has taken place. So I still feel as a share in terms of what they do, it still remains a very speculative asset, like asset—it’s far too small and stuff.

But other point which you raised, like, to me, is one of the problems of the global economy today, which is the extreme difference in the financial economies and the real economy, which is that the Chinese share of global economic output keeps rising. Today it’s about fifteen, sixteen percent. And yet, their share in the global financial economy is basically irrelevant, has declined. You know, all these people spoke about the internationalization of the yuan and what was going to happen. The 2015 episode where they slapped on more capital controls to prevent money from leaving was a massive step back in that direction in terms of it.

And, you know, like, I think there’s been so much talk today about Chinese expansion, overseas lending, et cetera. But one thing you have to take into account: I’m not sure what the ability of the Chinese to keep doing that is going to be. Their current account surplus has disappeared. So, in fact, you know, they’ll be running a current account deficit possibly soon. They were already doing it, like, in the odd quarter. And then their fixed reserves appear large, but they’ve stopped increasing in terms of it. And we are seeing some pattern, again, maybe of marginal decline. And as a share of their overall money stock, their fixed reserves aren’t that high, in fact. The number appears high, but if you look at the stock of money which is circulating like in China today, it’s not—it’s not that high.

So, yeah, I think that it’s one of those issues for which I don’t have an answer, but I don’t see bitcoin being the answer for it. But this dichotomy is a real problem for the global economy, but the dollar is so almighty, even though the U.S. share of global economic output is still about stable around twenty-five percent and everyone—China, et cetera, is rising.

But, you know, and the other thing which has failed people, I think—and this thing has been gold. Again, you know, we talk about what happens to these fads and trends. At the beginning of this decade, gold was such a popular asset in terms of how it was going to do, and here we are sitting at the end of the decade with the gold price having done nothing this decade. So, yeah, I think that this is one of those things where there’s no alternate to the dollar and it’s hard to see as to what will fill in that void.

TETT: Professor Reinhart and Brad.

REINHART: Let me make the following point. Chinese finance is very big in especially the low-income countries, but that covers a big share of the world. But their lending is in dollars. So saying Chinese importance is big in finance is not the same as saying the importance of the yuan is big or, you know, they are lending—this is dollar lending.

On the bitcoin, let me say I think one of the things that to me has been of interest is seeing it also emerge in cases where it’s a vehicle for capital flight. It emerged in Greece in 2015, in China at the time of capital outflows. It comes and goes. But I concur that at this time it’s still small potatoes.

TETT: Brad.

SETSER: Like, two years ago my research assistant convinced me that we had to do something on bitcoin and capital flight from China. And at the time, there was an almost perfect correlation between the price of bitcoin and measures of capital outflows from China. That correlation went away entirely. It turned out to be completely spurious, which I think probably informs my general sense of that importance of that question.

I think the key question, really key question is whether China’s reserves are adequate, and that hinges on a judgment about whether China’s reserves should be assessed relative to China’s domestic monetary base. And if you use that as the standard, China no longer is heavily reserved, which means it doesn’t have the capacity to use its reserves to maintain its currency in a way it has in the past.

Or if you think China’s reserves should be assessed relative to its external debt—in which case China is more than adequately reserved. It can pay off its entire external debt and still have, like, $1.5 trillion left. It is in no way in the same position of other weak emerging economies. Because it has controls, I don’t think the domestic monetary base is the right measure. But because of that, I also think it is far premature to think about China liberalizing its financial accounting. That is no longer in the world’s current interests.

SHARMA: Yeah, just one point I’ll make, that this entire thing that all because you have capital controls, you can avoid capital outflows, is not always true. As we know in emerging markets—and I come from India originally, I’ve seen this—that you can have all sorts of capital controls, but if people really want to get their money out of the country, they do. So, you know—

SETSER: Two things on this. One, China—yeah.

TETT: The U.S. Manhattan real estate market, yes.

SETSER: China’s control has proved more effective than most people thought.


SETSER: Particularly in limiting FDI outflows. And then, second—and this kind of links everything together—if China wants to increase its reserve buffer, or have more money available to finance capital outflows, it could stop some of its external lending to Pakistan, so forth and so on, which is generating about a hundred billion a year drain on its balance of payments. So there are policy choices there, but they have global consequences.

REINHART: Let me say also, look, China’s debt problems are internal. This is domestic debt. And this is a country that—I mean, provincial debt, this is not headline, you know, and we don’t read about it in the papers all the time, but provincial debts have been restructured. They have lengthened maturities, trimmed interest rates. This is what a credit rating agency would call a default, OK? Not a sovereign default, a sub-sovereign, provincial default. And they’ve been dealing with that. They have tools, like any country that is so close that the debt is domestic that are, you know, different from the open economy-type crises that we’re seeing in Argentina or that we saw in Thailand or, you know, other more open economy external debt-related problems.

TETT: Right, right.

Well, I must say it’s been a fascinating discussion. I mean, I take away three key points from this very wide-ranging set of debates. One is that we are in some ways seeing a very familiar emerging markets cycle develop as the U.S. raises rates. However, luckily, it’s not yet at a scale that’s going to spark serious contagion yet. I mean, some debate here. Although there certainly are some very, very interesting potential routes for contagion if things do get worse.

And a third point, perhaps most intriguing, is that China really has changed the dynamic in many ways. What we’re seeing with China being both a potential source of contagion and emerging market risk and a lender to many developing countries is very, very intriguing. We’ve not seen that before. So watch this space. And thank you all very much indeed for your thoughts. (Applause.)


This is an uncorrected transcript.

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