Title: From Crisis to Resilience: Emerging Markets Today
Introduction:
In the past, the saying “When the US sneezes, the global economy catches a cold” aptly described the concerns surrounding crises in emerging markets when the US raised interest rates. However, recent events have shown that this adage may no longer hold true. Despite higher US interest rates, emerging economies have exhibited resilience, leading to a reevaluation of the potential impact on global markets. This article explores the factors contributing to the improved strength of emerging markets and discusses why the risk of a widespread crisis may not be as significant as feared.
1. The Changing Landscape of Emerging Markets:
1.1 Resilient Economies: Emerging markets have become stronger, less wasteful, and better managed compared to previous decades.
1.2 Increased Currency Reserves: The accumulation of currency reserves has bolstered emerging markets’ ability to withstand external shocks.
1.3 Reduced Dollar-Denominated Debt: Many emerging economies have successfully decreased their exposure to fluctuations in the US dollar by reducing dollar-denominated debt.
1.4 Flexible Exchange Rates: Floating exchange rates have replaced rigid currency systems, minimizing the risk of depleting reserves and promoting stability.
2. Unfounded Meltdown Predictions:
2.1 Limited Contagion Effects: The spread of crises from emerging markets to developed economies has decreased significantly.
2.2 Isolated Challenges: While some individual emerging markets face challenges, there is no evidence of a systemic and contagious economic crisis.
2.3 Muted Impact on Currency: Emerging market currencies, such as the Mexican peso and Brazilian real, have appreciated against the dollar, indicating relative stability.
3. Factors Influencing Systemic Risk:
3.1 Size and Economic Importance: A market of significant economic importance would need to falter to have a global impact.
3.2 Financial Connections: Amplification and acceleration of a crisis require vulnerable financial systems.
3.3 The Element of Surprise: Quick and unpredictable developments have a more substantial impact than gradual crises.
3.4 Geopolitical Factors: Major conflicts could complicate the crisis and lead to unpredictable damage.
4. The Outlook and Implications for the US:
4.1 Peak of Rising Interest Rates: The worst of the rapid interest rate hikes in the US appears to be behind us.
4.2 Gradual Impact: The full consequences of higher interest rates will be felt over time as debt matures and rolls over.
4.3 Importance of a US Recession: Unless the US experiences a recession, higher interest rates are likely to persist.
4.4 Past Lessons: Historical events, such as the Asian financial crisis, have shown that the US can withstand emerging market crises without a significant impact on its own economy.
Conclusion:
Emerging markets have made remarkable progress in building resilience and reducing their vulnerability to external shocks. While isolated challenges may arise, widespread contagion is unlikely in today’s globally interconnected but robust economic landscape. The risk of a major crisis in emerging markets is lower than in previous decades, adding further confidence to the positive outlook. As the world continues on its perpetual journey from crisis to crisis, emerging markets are showing their ability to weather turbulent times and contribute to global economic stability.
Providing valuable insights into emerging markets, this article highlights that the once-accepted notion of the US contagion effect may no longer hold true. While risks remain, the overall resilience and maturity exhibited by emerging economies suggest a positive outlook for their continued development and global economic stability.
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When the US sneezes, the global economy catches a cold. Last year, the old adage aptly expressed widespread concerns about a crisis in emerging markets after the Fed began raising interest rates at its fastest pace in 40 years. Substantial stimulus measures had fueled an enviable recovery in the US but also helped inflation rise. Now the world would have to bear the burden of higher US interest rates, which would put emerging markets at risk.
But little of that happened. In fact, much higher US interest rates have had their effect on global capital flows, propelling the US dollar to near all-time highs. However, the gloomy forecasts of a meltdown in the emerging markets have not materialized. “Emerging markets are threatened with a historic cascade of defaults“” was a typical July 2022 headline. Was it a false alarm or a warning of a real crisis yet to come?
How to catch a cold
Concerns about the collateral damage of rising US interest rates are not unfounded. In recent decades, rising interest rates have often laid the foundation for emerging market crises. The Latin American debt crisis of the 1980s (after Paul Volcker’s massive rate hikes), the Mexican financial crisis of the mid-1990s (after Alan Greenspan’s tightening of monetary policy), and the 1997 Asian financial crisis (which spread to Latin America and the East). Europe in 1998) each have idiosyncratic drivers, but higher US interest rates played a role.
When US interest rates rise, economic infection can spread through various cascading effects. In response to higher US interest rates, local interest rates are rising, making their debt less sustainable. This, in turn, can make it harder for emerging markets to attract capital – or even drive capital flight. The effect is a strengthening of the US dollar and a weakening of emerging market currencies, a particular problem for fixed currency systems or for those who have borrowed in dollars rather than local currency. In addition, higher US interest rates are expected to slow the US economy and reduce export volumes and remittances to other countries.
Emerging market economies are more robust today
Although the infection channels have changed little, emerging markets are now more resilient. A sneeze in the US no longer automatically means emerging markets will catch a cold.
Certainly, isolated challenges in emerging markets continued to intensify, including in Sri Lanka, Pakistan and Zambia. Both emerged before the US rate hike cycle, although that likely exacerbated their problems. However, there is no evidence of a systemic and contagious Economic Crisis – the way the Asian financial crisis infected economies worldwide in the late 1990s.
Why are emerging economies more robust today than they were in the 1980s and 1990s? Put simply, they are now, on average, stronger, less wasteful, and better run economies, despite being a diverse group.
Critical economies have increased their currency reserves and thus strengthened their resilience. Many have successfully exited dollar-denominated debt, reducing exposure to currency fluctuations as local currency liabilities have become more important. And currency rigidity, which can quickly deplete reserves, has given way to floating exchange rates.
Better management also pays off. In recent years, prudent fiscal policy in these markets has led to less pandemic-related economic stimulus – and thus less new borrowing – than in the US and other developed countries. And many were quicker to respond to post-pandemic inflationary pressures – indicating independent and credible central banks.
This underlying resilience is also visible in the markets. Emerging market currencies such as the Mexican peso and Brazilian real have appreciated against the dollar, while their developed market counterparts (euro, yen) have weakened since early 2022. And the spread between long-term interest rates in emerging and developed markets has widened and remained narrow.
Full immunity is not realistic
While resilience is important, there is no complete immunity from the risk of infection. More isolated EM crises are to be expected. In fact, the bottom decile of emerging markets has negative growth for most years, a proportion rarely seen in developed economies. But widespread contagion is a higher hurdle.
A crisis of global systemic importance would require a combination of different factors. First, size. A market of significant economic importance would have to falter to have a global impact. It is estimated that the ‘spillover effects’ from emerging markets to developed economies are justified a fifth of those fleeing from developed to emerging countries. Second, financial connections. A downturn in the real economy alone is not enough to drive rapid and damaging contagion – financial systems would need to amplify and accelerate the crisis. Third: surprise. If a crisis develops over time (which can often be the case as governments try to contain the problem), markets and banks are often able to adapt and limit the damage. Finally, geopolitics. A major conflict could increase complexity and cause unpredictable damage.
What is the tactical outlook? The worst of the rapidly rising US interest rates is behind us and the peak is in sight. Meanwhile, the dollar has already retreated from its decade highs, easing the pressure. However, unless there is a recession in the US, the higher interest rates are likely to remain, and the full impact of the higher interest rates will only be felt gradually as the debt matures and has to be gradually rolled over.
Spreading the disease but not catching it?
What does the risk of an EM crisis mean for the US? In the past, the damage caused by crises in emerging countries was often overestimated. The US escaped the worst of it, perhaps unjustly as rising US interest rates were often the catalyst. The US may sneeze, but not catch a cold.
Consider the Asian financial crisis of the late 1990s. It spread from Asia to Latin America and Eastern Europe and via Russia to the USA. Its biggest victim in the US was LTCM (Long-Term Capital Management), a large hedge fund that had to be bailed out by its own bankers in September 1998. The systemic risk was undeniable and the mood was downright frightening. Even Alan Greenspan, then Chairman of the Federal Reserve Board called“It is simply incredible that the United States can remain an oasis of prosperity without being impacted by a world suffering from escalating stress.”
But despite the routes of infection that led back to the USA, the disease was contained. Quarterly GDP growth in the US did not fall below 3% after the second quarter of 1997 and was generally much stronger. The slump came only when the domestic dot.com bubble imploded after the end of the EM crisis.
Global macroeconomics is always a journey from crisis to crisis – without settling into the equilibrium of textbook economics. Emerging market crises have dominated global concerns in the past – and likely will continue to do so. But there are good reasons why that is not the case today. Demand a heavy burden of proof from those who claim otherwise.
Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s chief global economist. Paul Swartz is a director and chief economist at the BCG Henderson Institute in New York.
The opinions expressed in Fortune.com comments are solely the views of their authors and do not necessarily reflect the opinions and beliefs of wealth.
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