The U.S. economy and its financial markets continue to plow ahead, ostensibly immune to any effects of monetary tapering. After a New Year swoon, the S&P500 has now essentially recovered all of its losses and any perceived weakness in retail sales, housing or employment is just dismissed as a soon-to-be-corrected weather related anomaly.
Instead, the financial gods seem to be directing their fury towards emerging markets. International bond and equity funds dedicated to developing countries continue to sustain substantial outflows, and many currencies saw yet another round of depreciation since the New Year. The pressures that begun to affect most emerging market economies in the Spring of 2013 seem to have only deepened in 2014.
It is tempting -- and indeed popular -- to fault the U.S. Federal Reserve and accuse developed countries of being selfish and ignoring the plight of others. There is some superficial merit to the argument. Financial stresses first developed when the Federal Reserve signaled its willingness to reduce large-scale asset purchases. And at least some of the selloff is undoubtedly due to the unwinding of carry trades associated with revised expectations about the future path of U.S. interest rates.
Some blame should also be placed on the prospect of an economic slowdown in China. Renewed weakness in Chinese manufacturing threatens serious damage to commodity exports in much of Asia, Latin America and, now, even Africa.
But much of the responsibility must surely be laid at the feet of domestic policy makers. It is already apparent that the deterioration in financial conditions varies considerably across countries. Investors are noticeably making distinctions between emerging economies, according to their perceived economic vulnerabilities. The Indian Rupee, Brazilian Real and Turkish Lira have all fallen by about 15 percent or more during this period. By contrast, currency depreciations in countries like Malaysia, Mexico and the Philippines ranged only about 7-8 percent. And the Korean Wan and Taiwanese Dollar have barely moved at all.
Despite all their protestations, policy makers could not have been surprised at these developments. There are many obvious reasons for these observed differences in currency performance -- and associated spikes in sovereign yields. They all have to do with the quality of the management of their domestic economies.
One such reason is the very different state of current account balances, a perfect measure of a country's net borrowing from the rest of the world. In India for example the current account went from near balance in 2007 to a deficit of almost 5 percent of GDP in 2012. The numbers are less dramatic for Brazil, but Turkey charged an extra 6 percent of GDP to the nation's credit card balance in 2012, after having added a scarcely believable 9.2 percent in 2011. By contrast, countries like Malaysia, Philippines and Thailand have no current account deficit al all. Mexico does have one, but it has remained well under control at about 1-1.5 percent of GDP since 2007.
Turkey's government has allowed its deficit to become persistently, and irresponsibly, large, but India and Brazil might be excused were the economies expected to grow significantly in the next few years. A nation's expected GDP growth will matter as much to international investors as an individual's income prospects in credit card applications. Each may be ignored when credit conditions are fairly loose, but they will be tested carefully when its time to tighten. Experienced central bankers should know that. Brazil, India and Turkey did see significant growth in 2010 and 2011. But the last two years were increasingly disappointing and strong growth is unlikely to return until 2015 or 2016 at the earliest.
Sharply rising prices offer another hint that the rapid growth in recent years was excessive and not likely to be sustained. Official statistics now place the inflation rate between 6 percent (Brazil) and 9 percent (India). This clear lack of monetary discipline will have to be addressed at some point. But credible inflation fighting requires higher interest rates and a further dent on already diminished growth prospects.
An out-of-control growth in domestic bank credit is another clear-cut red light for foreign investors. Both long history and recent memory should caution policy makers to steer well away from the credit sirens. And yet in Brazil, between 2008 and 2013, domestic credit to the private sector was allowed to surge from 53 to 69 percent of GDP. The credit explosion in Turkey was even greater.
For a loose comparison, imagine being handed resources (over 5 years) equivalent to the entire budget of the U.S. Federal government (about 17 percent of U.S. GDP) and trying to decide how to spend that. Was enough of this borrowing productively invested? Were there so many brilliant projects waiting to be funded in São Paulo or Istanbul? We will soon find out.
Foreign pressures have clearly played a role in creating the current economic dilemmas facing economies like Brazil, India and Turkey. However, primary responsibility must rest with domestic central bankers and politicians who failed to heed obvious warnings signs and allowed too many economic imbalances to develop since 2009. They have only themselves to blame for the tough choices that face their countries in 2014 and beyond.
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