Emerging markets are surviving the financial crisis

The author is a Senior Economist at Oxford Economics

To say that emerging markets would struggle in times of global financial stress was a safe bet — their financial problems were a canary in the global economic coal mine.

In the past, such predictions would almost certainly pan out, but this time it looks different. After more than a year of deterioration, emerging market financial conditions appear to be stabilizing. The general impression is that emerging markets are doing fairly well with the current global financial crisis. This is mostly a result of their total newfound caution but as always private factors play a role.

China is now among the few emerging markets that are easing monetary policy, but this still provides a tailwind to the economy and not just because of the country’s lockdown policies. While the People’s Bank of China has lowered its policy and reserve requirements, stock market losses and the continued battering of the real estate market mean that there is still no clear sign of improvement in financial conditions (even if the deterioration stops).

Credit and money are rising in China but not as much as in previous episodes of fiscal stimulus. Getting the real economy running at full speed again requires more targeted policies.

On a broader note, foreign investors are not “punishing” emerging markets as much as they have done in previous episodes of increased risk aversion – bond spreads on developed markets are extraordinarily high in only a few countries such as Turkey and Eastern European countries. Rising prices are seen most clearly in government debt in local currency, but even here, Eastern European countries are mostly seeing rising inflation due to the energy crisis in Europe, heightened risks of approaching war in Ukraine, and declining financial markets liquidity as foreign investors move away from higher risks. And the most bleak political prospects.

The exchange rates story is more accurate. Emerging markets have generally benefited from starting the tightening cycle early and decisively, but this has not been decisive in determining the fate of their currency. True, on average those countries that have raised their policy rates the most in the past two years have seen less depreciation and even some currency strengthening, but the correlation is less than perfect.

The strength of some emerging market currencies is private (such as Russia), and some is commodity-related (oil producers enjoy the boon of oil revenue). But there is broader weakness in the Asian currency that policy spreads alone cannot explain: both tightening and resistance tools are seeing currencies weaken.

However, it is more likely that the trend will reverse in weaker Asian currencies rather than trigger a new financial (or debt) crisis. Local currency and long-term debt are more prevalent today than they were in the 1990s, and Asian economies now hold huge foreign reserves. Today’s global financial system, with its vast reserves of idle liquidity, bears little resemblance to the infamous Asian financial crisis.

Be that as it may, a stronger dollar has traditionally meant trouble for emerging markets, not only financial but real as well: the EM trade-weighted dollar index tends to correlate negatively with EM’s real activity. But this time, the relationship didn’t hold up. This is rare, but it does happen.

Despite continued dollar strength, emerging markets managed a strong rebound from a weak correction earlier in the year. Some slowdown in growth is to be expected, as the global economy prepares for a downturn if not a recession, but what is surprising is the dollar’s imbalance rather than the usual emerging market weaknesses. The uptick in the Covid recovery has not been as strong as in advanced economies and the slowdown is now moderate.

Meanwhile, emerging stock markets have now lost all the gains of the post-pandemic recovery, although the performance is lopsided. Likewise housing prices. While China appears to have weathered the worst correction in the housing market, Eastern European countries are going through a sharp downturn.

But thanks to early monetary policy tightening, most emerging markets facing high inflation have managed to turn around and may now be close to their peak price levels. The dollar also looks close to its top, and liquidity is under control in the majority of emerging markets, with the exception of Eastern Europe. Given that this is due to a European conflict rather than a broader emerging market crisis, we can conclude that developing economies have delivered on the promise of prudent policy and macro stability.

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