A long and wild feast has now come to an end in the US and other advanced countries. The barmen are trying to close up but the guests have not yet paid the bill and are staggering around feeling very ill.
There might be a difference between the current US recession and the one in 2001. As has been said, the recovery after the 2001 recession was the best that money could buy. But this time US families may seriously start rebuilding their balance sheets, increasing their savings and perhaps even enabling the country, but certainly not the government, to borrow less from abroad.
Barely a month ago, the macroeconomic outlook in most advanced and emerging economies was one of lower growth and higher inflation. The outlook today is plainly one of recession.
Most likely, this US recession will be deep and lasting. The news of a L- or at best U-shaped US recession dramatically changes growth prospects in emerging countries. One on hand, a number of countries were enjoying exceptional terms of trade. These good terms of trade were created by profligacy in the north –via China– and good credit conditions. Those good credit conditions in turn were supported by thrift in the Far East.
Financial markets in emerging countries
Emerging-market currencies depreciated as global risk aversion increased. Depreciation was first higher vis a vis the yen reflecting the unwinding of carry trades with Japan. The Euro depreciated against the dollar with news of the weaknesses of the European banking system and, as pointed out by Brad Setser is this same blog, during the unwinding of US carry trade. The appreciation of the dollar was somewhat of a surprise since a financial crisis usually come along with a currency crisis; there might be an exception to this rule, the one of the country that emits the world reserve currency when all other currencies are not attractive because of financial system failures and increasing risk aversion.
Emerging-country credit markets are under increasing strain due to the global credit crunch, as well as the deterioration of current accounts and the need to refinance existing bond emissions that will eventually come due.
Emerging-country interbank markets exhibit the luxury borrowing and lending for more than one day, a luxury that advanced economies currently cannot bear. Even so, countries like Brazil, Chile, Peru and Korea have taken measures to provide liquidity in the interbank markets.
Emerging-country bond markets were dominated by the unwinding of the dollar carry trade and by the increase in global risk aversion. EMBI spreads increased worldwide. Despite higher spreads, it would be impossible to place a one-penny bond. Higher EMBI spreads also reveal the lower, near zero or even negative, return on treasury bonds.
Emerging-country equity markets sank reflecting higher risk aversion, lower growth prospects and a drop in the price of commodities.
The outlook for emerging markets
In emerging Europe, the eventual closure of European credit markets could be fatal. These countries have been running enormous deficits in the current account and their banking systems are made of branches of foreign (European) banks. A drop in capital inflows, current account reversals, currency and banking crisis and hard landings cannot be ruled out.
While the whole of Asia was providing much of the savings that fueled the excesses of the West, there is some heterogeneity within countries, low income countries (India, Pakistan, Sri Lanka and Vietnam) are at risk of current account reversals as their foreign balance was in the red before the global financial crisis.
The current account of Latin America was somewhat balanced before the global crisis, lower expected exports point to a switch of the current account into deficit territory at a time when finding foreign savings are difficult to find.
Capital accounts are under stress due to the virtual halt in credit markets. Current accounts will also be under stress due to the drop in the terms of trade as well as to the US recession. In normal times this means soaring credit spreads and plunging currencies. But this time currencies have been somewhat resilient perhaps due to the simultaneous increase in credit risk in the United States and because of the medium term prospects of a weakening dollar. In addition, emerging-country fundamentals can be considered relatively strong compared to those of advanced economies.
The closure of credit markets may force some rebuilding of balance sheets in emerging markets. Financial positions are currently not critical and the global crisis may lead to a further improvement in balance sheets.
Emerging countries’ balance of payments will also be hit by lower remittances.
The tremendous raise in the terms of trade commonly attributed to the Chinese locomotive may have come to a halt altogether. The true locomotive was the US consumer since most Chinese imports work as inputs for their exports; value added is only but a part of exports. To put this graphically, the goods in a cargo ship that visits a Chinese port may count as imports and exports but an increase in the terms of trade cannot be propelled without growth in demand somewhere else. Now that the locomotive has run out of steam, emerging countries’ terms of trade may not be the driver that is has been in the past.
Countries at risk of a halt in the foreign credit may want to avoid currency depreciation, particularly those with debt in foreign currency. The use of foreign exchange by the central banks may act as a stabilizer, but a raise in interest rates would add to the hard landing. As long as the currency composition of balance sheets permits, currencies depreciation would be a step in the right direction because it would help increase net exports.
Regarding monetary policy, lower food-commodity prices is good news for inflation in the short term. Nonetheless, the relatively small currency depreciation already observed may offset part of the taming effect of lower international food prices on inflation. In the medium term, as the global financial crisis increases the risk of a hard landing, inflation may be brought back again in line with targets.
As to fiscal policy, most countries will have no choice but to implement procyclical fiscal policy; this means expenditure cuts at the time of the hard landing. Only Chile may let the fiscal stabilizer operate.
Emerging countries and the new global (im)balances
Provided credit and interbank markets return to normality soon, the adjustment of the balance sheet of American families may imply a surge in private savings that may even be larger than the increase in the government deficit (if other country’s crisis are to be of any guide for the case of the US). Were America to stop swallowing world savings, Asian and Middle East surpluses may still serve a purpose in those countries whose current accounts are shifting to the red.