Emerging Markets have always been seen as a lucrative growth opportunity for investors, but with high returns come high risks. What may seem like an attractive investment on the surface may have many unforeseen structural issues underneath. Global markets learnt this the hard way just over twenty years ago, as the Asian financial crisis struck and many South East Asian countries fell into recession. Twenty years on, I will now examine what happened and look to see whether emerging markets have learned from Asia's mistakes.
A note on economics
In order to better understand the analysis I am about to present, it is important to recognize some fundamentals of international economics. Firstly, a lot of my analysis will be around emerging market debt. Typically, due to better liquidity, emerging markets tend to issue dollar denominated debt. This is not an issue when interest rates are low, however during the Asian crisis and in the last few years, rising US interest rates coupled with falling domestic currencies mean it is harder for companies and governments to repay debt. As investors realise this, they end up pulling more money out of the economy leading to further pressure on the currency and it makes it even harder for the emerging market country to service its debt. This leads to a vicious cycle and partly explains why you tend to see currency and debt crises together. These problems can further be exacerbated by a few more factors. Short term debt can be problematic because foreign lenders can refuse to refinance it. This can create a policy dilemma for governments who may want to raise domestic interest rates to help the currency; however this may harm domestic borrowers and banks' loan returns. You may be asking at this point – given all these risks, why do so many countries pursue these strategies? What must be understood, however, is that these countries are still developing, meaning they may not have the appropriate institutions in place to facilitate large amounts of international finance. This may mean for example that the correct due diligence is not done before proceeding with an investment, therefore it may be riskier than originally perceived. This will be the case for some of the examples examined here and this phenomenon does, In fact, have its own name – irrational exuberance.
What happened 20 years ago?
In the 1980s and early 90s East Asia was experiencing an unprecedented export-led boom in
growth. Although one should be careful lumping all the countries together, their success during this period can generally be attributed to a combination of a relatively cheap and well-educated labour supply, falling external barriers and (in some cases) heavy inward investment. These strong economic conditions, coupled with a period of relatively low US interest rates, fuelled an investment boom into the region which led to rising asset prices and eventually bubbles. This proved to be a ticking time bomb however, as a lot of investment in the region had been done by borrowing cheaply in dollars and lending in the more profitable domestic currencies. While interest rates were low this was not an issue, but in the latter part of the 90s the US started raising interest rates and many firms struggled to repay their foreign currency debt. Figure 1 shows how indebted these countries were; 30% is typically seen as a benchmark beyond which the debt is unsustainable.
With the currencies fixed (either partially or fully) against the dollar, many of these countries started racking up large current account deficits which weighed heavily on their FX reserves. Each year that a country had a deficit on its balance of payments, in order to maintain balance, it would lose some of its foreign currency reserves. This meant it had less money in order to maintain its currency peg. As one can see, this is far from sustainable. Coupled with these issues, a lot of borrowing that was done in the region was short-term debt. This was problematic as it had to be repaid quickly and was similar to how a company may face cash flow issues; rising interest rates made these countries suffer repayment issues. Figure 2 demonstrates how unsustainable this was.
This mixture of foreign debt reliance, fickle short-term lending and current account woes lead to a perfect storm for a textbook currency crisis. On July 2nd 1997, the crisis officially started when the Thai Baht broke its peg with the US dollar as they were lacking in reserves to support the currency. This led to massive hot money flows out of the region, which then lead to a contagion effect across other countries. Eventually, the IMF had to step in and issue rescue packages to support the region's currencies and economies as long as they followed certain economic conditions. I will now look at a few recent crises and see if parallels can be drawn.
Delving deeper, it is easy to draw parallels with Asia to understand what happened. Turkey's economy has had a turbulent time in the past 20 years, suffering a few major crises. Most recently earlier this year, similar to the Asian crisis, investor sentiment turned sour and the country was plunged into a debt and currency crisis. This can be attributed to deteriorating economic fundamentals and the president's increasingly unorthodox economic views.
Although in the past investors may have shrugged off his rhetoric, Erdogan has recently questioned the independence of the central bank and gone as far as to say that "interest is the mother of all evil". This shift in tone shocked many, and coupled with increasingly aggressive rhetoric against the US, has led to the most recent sell-off. From a longer-term perspective, ever since the authoritarian leader Erdogan took power; the region has been running growing current account deficits (see Figure 3). As with the Asian countries, Turkey was forced to fund the deficit through its FX reserves. It had been managing somewhat well, however this was again unsustainable due to its reliance on foreign capital inflows. Once again, there was a large reliance on foreign debt as well, with over 53% of debt (as a % of GDP) coming from external sources – well above the 30% threshold of Figure 1. One could argue that Turkey's situation is far more dire, however. The Turkish Central Bank (TCB) has been in a battle to tame inflation, much to the dismay of Erdogan. Prices have risen almost 25% on a yearly basis, causing the central bank to raise interest rates to a staggering 24% from 4.5% just a few months prior. The crisis itself is still ongoing; therefore more time will be needed to see how the country will manage.
The economy of Brazil has oscillated between incredible highs and lows of economic growth, reaching heights of over 8% and lows of -6%. This is another example of reliance on international markets. However, Brazil is different in that it relies heavily on commodities. The most recent post-crisis growth spurt has been driven by demand from China for Brazilian commodities, so when China started slowing down, Brazil felt the pressure (see Figure 4).
This deterioration is reflected in the current account balance, which has slowly become more negative, reaching a low of -4.2% in 2014. The worsening trade balance and lower demand for Brazilian exports has put significant pressure on Brazil’s currency, the real, pushing it to its lowest level in over 20 years against the dollar. This alone was not the only reason for Brazil's demise; as with Turkey, political woes were rife as a former president was removed from office, and a far right leader has just been elected. Poor fiscal management has also plagued the nation, with government debt (as a % of GDP) ballooning from around 50% in 2013 to close to 75% in 2018 – nearly a 50% increase in just 5 years.
The crisis in Venezuela is one of the worst economic crises to hit emerging markets in modern history. Similar to Brazil, Venezuela depends heavily on commodities – in particular oil – with one of the richest oil reserves globally. Oil revenue has helped sustain the economy for a number of years, but it also makes it rather vulnerable to fluctuations.
The government used the surplus oil money in the past to fund social programmes and food subsidies, however as the oil price fell these policies became unsustainable and the government built up a substantial deficit (Figure 5). The poor economic conditions have lead to investors scrambling to pull funds out of the region and the currency has tumbled dramatically. To try and combat this, the government has tried to enforce currency controls; however, these have put a strain on supply, as imports were cut significantly. This inability to pay for imports, coupled with the decline in oil revenues, has led to a momentous shortage of goods. Extreme government intervention to curb the currency has led to the government trying to control the exchange rate. In trying to fix the value at a rate which makes it significantly overvalued, a black market was created. This in turn, coupled with the extreme shortage of goods, has meant the country also suffers from significant hyperinflation.
After reviewing a number of case studies, I believe it is fair to say that emerging markets have some way to go. Although many Asian countries have now recovered, poor institutions and political instability make many developing countries susceptible to the mismanagement of public finances. Although one cannot draw direct parallels between the Asian investment boom which preceded their crisis, it is easy to see how structural deficiencies, coupled with political issues, have led to some of the crises described above. Looking ahead, Turkey is still muddling through its crisis and Brazil has just elected a new leader - only time will tell as to how these nations will cope in the future.