The business press is full of dire predictions about sudden capital outflows from emerging economies, with a growing list of 'fragile' countries. Few commentators can resist making some reference to the disastrous 1997-98 Asian crisis, just to add an element of frisson to the story. But a repeat of 97-98 is extremely unlikely.
In recent years, particularly after the 2008 global financial crisis, we've come to revise our understanding of the Asian crisis.
Initial explanations identified the key cause as 'crony capitalism': monopolistic chaebols in South Korea, self-interested financiers in Thailand and the Soeharto clan in Indonesia.
These early explanations also blamed dirigiste economic policies, at variance with the internationally fashionable Washington Consensus. If a country was in trouble, it must be because it had strayed from the free market path. To restore order, budgets should be cut back and interest rates raised.
The 2008 global financial crisis showed that even advanced economies can get into trouble. Perhaps the best demonstration of the rethink was that the remedial policies of 2008 were, in general, the polar opposite of those practised in 1998.
The revised narrative of the Asian crisis gives a central role to the grossly excessive capital inflows in the five years prior to the crisis. At the time, capital flows were widely seen as unambiguously beneficial. The IMF tried to have free capital flows written into its articles, accorded the same status as free trade. Any policy measure which tried to manage or limit these inflows was roundly condemned as ‘capital controls’.
The graph in this post tells the story. In the early 1990s, global financial integration brought a flood of capital into the fast-growing emerging economies.
Thailand, the first domino to fall, had inflows equal to 13 per cent of GDP in 1996. As a result, the exchange rate came under inexorable upward pressure. This, together with the inflow-fuelled booming economy, opened up the external deficit to 6 per cent of GDP.
With an uncompetitive exchange rate and an asset price boom, Thailand was a house of cards set up for a fall. Its neophyte financial regulators were not up to the task of protecting it. When the baht went into freefall in mid-1997, the contagion spread first to Indonesia and then Korea, which had both also been the recipients of excessive capital inflows.
There is much more to this story, particularly the inadequacy of the IMF-led rescue operations. But the point to be made is that pro-cyclical volatile international capital flows played a central role in the Asian crisis.
How does this relate to today's fragile emerging market economies?
Financial flows to emerging economies are now larger than in the 1990s and just as volatile. But most of the emerging economies have learned the lesson.
Indonesia provides an example. Having been singled out by financial markets as a member of the 'fragile five', Indonesia trimmed the budget deficit by reducing petroleum subsidies, tweaked its interest rates higher, allowed the exchange rate to depreciate significantly, allowed the slowing economy to improve the external deficit, and backtracked on some of the economically dubious policies that accompany pre-election populism. Similarly, India and Brazil have tweaked policies to reduce vulnerabilities.
In short, most emerging economies are in far better shape than in 1997: scarred, wiser and far more experienced.
Can the same thing be said about the foreign providers of the capital? To make sense of the global financial sector's current on/off capital flows, we have to understand that their country-specific knowledge is shallow. Portfolio managers are guided by simple rules of thumb, with their main attention focused on other players in the same market. When their fellow lemmings start running in the opposite direction, everyone wants to be immediately behind the pack leader.
The rules of thumb are crude. They include simple limits on external deficits, budget deficits, foreign debt and inflation. This crude evaluation system disciplines behaviour in emerging economies, perhaps unnecessarily. Bolder policies might boost infrastructure spending and speed growth. But most emerging-economy policymakers accept that global markets won't understand the subtle detail of more optimal policies. One day the lemmings will be spooked and run, taking their money with them.
Not all countries accept this externally dictated discipline. Countries like Argentina and Turkey are walking a tightrope. If, like Thailand, you want to have a political crisis, you need to be running an external surplus – as Thailand is. If you want to administer a huge credit stimulus that raises domestic debt sharply (as China did in 2009, saving the world from a much deeper recession), then you need a government with untrammeled policy powers, capital controls, an external surplus, and more foreign reserves than it knows what to do with.
Most emerging economies, however, accept the discipline. Their best tactic is to loudly proclaim their own virtuous prudence in the hope that foreign investors learn that emerging markets are not all the same.
This is not an ideal world. Over time, emerging markets need to find more 'patient' capital, such as foreign direct investment and long-term bond-holders. When they do, this will give them the freedom to actively discourage the volatile short-term capital flows that have proven so damaging.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.