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The Emerging Markets' Summer Meltdown: Is It Ben Bernanke's Fault This Time?

09/09/2013 06:00 pm ET | Updated Nov 09, 2013

"Does the rupee crisis parallel the 1997-98 Asian collapse?", I was asked by a Canadian Broadcasting Corporation TV news producer before an interview. This got me more than a bit nervous: What am I missing? Sure, the rupee had fallen 10 percent since mid-July; global business had lost confidence in the Indian economy and in the government's stewardship abilities; we are all weary of unending depressing news of corruption and social ills. But is India really a harbinger of a much deeper rot worldwide? How are the trials and tribulations of the rupee, the Brazilian real, the Turkish lira, the South African rand and the Indonesian rupiah connected?

Recall that, back in 1997, the crisis began with a 20 percent devaluation of the Thai baht, which set off a chain reaction in currencies, cutting across Malaysia, the Philippines, Indonesia, Singapore and South Korea, with bank collapses in Japan and dizzying drops of stock indices from Hong Kong to New York. The Malaysian Prime Minister Mahathir probably took the prize for the most imaginative conspiracy theory behind what went wrong then: It was all the fault of the billionaire investor George Soros and his dastardly speculative activities. Today's simple theory -- albeit not as far-fetched or even imaginative -- connecting all falling currencies points the finger at the U.S. Federal Reserve and its outgoing chairman, Ben Bernanke. The anticipated "tapering" of the $85 billion-a-month asset purchases signaled by the Federal Reserve will mean that international investors hungry for returns will exit emerging markets and seek sanctuary back in the U.S. This would, superficially, explain the synchronized slide in emerging market currency exchange rates.

Collectively, the slide makes for a rather dramatic turn given how recently the emerging markets represented the only bright spots on a gloomy global economic landscape. They were growing twice as fast and were quicker in their bounce-back from the 2008 crash, when compared with the developed markets. My old firm, McKinsey, had done the arithmetic on their market potential: The emerging world represented a $30 trillion "decathlon." Even the U.S. National Intelligence Council was speaking in terms of a tectonic shift with the rise of a new global middle class.

Fast-forward to the summer of 2013. Companies with significant emerging markets exposure are being advised to veer away from the $30 trillion market bonanza. Hot money is exiting emerging markets matching the alacrity with which it rushed in during past years.

Speaking of hot money, just as George Soros cannot be held responsible for the 1997 Asian crisis, it is equally silly to cast Ben Bernanke as the singular culprit behind the emerging markets' 2013 summer meltdown. The exit from these economies may be speculative and short-sighted, but it offers up an excellent opportunity to examine what is left behind; as Warren Buffett said, only when the tide goes out do you discover who has been swimming naked. In other words, without the cover of hype and exuberance, we can now take a closer look at the rot that exists within the emerging markets themselves.

The real scourge resides well within these markets. Even as the economies clocked high growth rates, the contexts surrounding them barely kept pace, leading to an impossible imbalance. It is no coincidence that the emerging middle class (the very basis for McKinsey's $30 trillion prize) have in recent months taken to the streets in Brazil, Turkey, South Africa, India and elsewhere. In fact, when Brazilians hit the streets to protest against their "beautiful game" of soccer, it is a sign of how far the imbalance has gone.

India offers a good case study of the three main problems created by the imbalance between a fast moving economy and slow moving context: a near-term emergency that requires an emergency fix; a longer-term sustainability problem; a broad loss of confidence among investors and other business partners, entrants and stakeholders.

Near-term emergency: There has been no systematic policy for growing and diversifying the export sector and for creating incentives for import-substitution. Now the devaluing rupee is an acute problem with the current account deficit (CAD) at $90 billion, while the foreign exchange reserves are at $275 billion, which means that the ratio is at a dangerous low. Added to this is the $170 billion in short-term debt, which would have to be repaid soon if it cannot be rolled over. This is a recipe for a downward spiral. The country celebrated its IT and services sector and the deficiency in manufacturing was simply allowed to persist, as have widespread inefficiencies in regulations, licensing and subsidies. Each contributed to lop-sided growth and compounded the CAD problem -- and now there are emergency measures being thrown at it.

Longer-term unsustainability: India shares a characteristic common to most emerging markets. While the economy has grown rapidly, there are missing political, legal and social institutions, overcrowded cities, underdeveloped infrastructure and no real commitment to substantially improving the wretched state of the human condition. While the media and the analysts celebrated the growing middle class, 70 percent of the population lives on less than $2 a day, without access to the basic minimum of resources, such as clean water, financial access, housing, education or health. In the absence of a better balance between the economy and these other factors, the economy simply cannot get too far out on its own.

Loss of confidence overall: While businesses and investors are drawn to the opportunities presented by a market such as India, with a burgeoning middle-class and a significant entrepreneurial culture, they need to be assured that the risks are manageable. India's political calculus is complicated and often hard to decipher: a coalition government at the center with many stakeholders to appease and high variability in political will across the states. The result is an unpredictable and non-linear pattern in regulatory changes and reforms. All of this makes the environment a perfect breeding ground for corruption and bureaucratic red-tape. In addition to inadequacies in political reform, legal and social reforms have also lagged. Movements for creating new states, festering insurgencies, a seemingly unending stream of cases involving rape, pervasive criminality in the twin obsessions of cricket and Bollywood, and other social ills continue to tarnish the perception of the country as a whole. There is an urgent need to "de-risk" India.

As with all moments of crisis, there are opportunities. It was, after all, the 1991 crisis that forced India down the path of reform. The 1997 crisis was a chance for the Asian tigers to reflect on their vulnerabilities, learn the lessons about dangers of high leverage ratios and unchecked credit growth and take steps to re-set the foundation for a potential "Asian century" to follow.

Let us hope that in that this summer's meltdown is similar to 1997, at least in that one aspect: it is another opportunity to not let a really good crisis go to waste.