If ever one is looking for an example of hope triumphing over experience, look no further than emerging market economies.
At the very time the Federal Reserve is tightening US monetary policy, both investors and policy-makers in those economies seem to be in denial about the likely fallout of such a move for emerging markets. They cling to the hope that somehow this round of global liquidity tightening will be different from earlier ones.
There is no shortage of indications of emerging market investors’ positive frame of mind. The interest rate spread of emerging market corporate bonds over US Treasuries is close to its record low. Despite some recent widening, emerging market sovereign debt spreads remain low by historic standards. And investors keep oversubscribing to debt issues by countries with very weak credit, such as Iraq, Kenya and Mongolia.
Emerging market policy-makers are not preparing for a rainy day. Rather than using the good times to reduce their governments’ debt levels, they keep taking advantage of favourable global liquidity conditions to tap the market. The International Monetary Fund estimates that sovereign debt to GDP has now reached levels last seen during the emerging market debt crisis of the 1980s. Emerging market policy-makers have done little to rein in their corporates’ borrowing sprees, even though those corporates have almost trebled their debt since 2008.
Previous Fed tightening cycles have not been happy ones for emerging market economies. Rising interest rates in the US have generally resulted in the large-scale repatriation of capital that had flowed in when US interest rates were low, causing serious financial market strain and acute balance of payments pressure for those countries.
Both investors and policy-makers seem to be counting on stronger fundamentals to make emerging markets more resilient to conditions of reduced global liquidity than they were before. They are turning a blind eye to greater sovereign and corporate indebtedness. They are also overlooking big imbalances and political challenges in some of the largest emerging market economies, as well as the fact that a large amount of recent borrowing has been by countries with very low credit ratings.
Some major developments have escaped investors’ notice. Brazil’s public finances are on an unsustainable path at a time when it faces a contentious presidential election in October. There is a very high probability that Andrés Manuel López Obrador, the left-leaning populist, will win Mexico’s July presidential election. That could very well put Mexico on a collision course with the US and could lead to the reversal of the country’s energy reforms.
China is experiencing a credit bubble of epic proportions and is at risk of drifting into a trade war with the US. Turkey could face a currency crisis as President Erdoğan primes the economy ahead of forthcoming parliamentary elections.
To prevent the US economy from overheating, the Fed may have to increase interest rates at a faster pace than it was planning to. This seems likely, considering easy US financial conditions and expansionary fiscal policy at this late stage in the economic cycle.
If this happens, we will not have long to wait to see if emerging markets fare better with global liquidity tightening than they did before. Judging by their high debt levels and deteriorating economic and political fundamentals, I am not betting the house on the notion that this time will be different.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.