The Next Emerging Market Crisis

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

Do the world’s middle-income countries - known in the investment business as “emerging markets” - face a serious risk of crisis? If such a crisis unfolds in one country, could there be contagion, with panic spreading around the world?

My answer is a cautious “no” on both questions. But it would be a mistake to dismiss or ignore these questions, in part because they are being asked by smart people in financial markets and in part because sometime in the not-too-distant future the answer could be a decisive “yes” - with disastrous consequences.

There are three main sources of concern.

First, India faces real economic difficulties, building up to a type of crisis, as I explained here last week. Arvind Subramanian, my colleague at the Peterson Institute for International Economics, said in The New York Times over the weekend that the slowdown in Indian growth had longstanding causes and a quick recovery did not seem to be in the cards.

Most financial crises begin with one weak country and then spread as investors re-evaluate prospects more broadly. The 1982 “developing country debt” crisis was brought on initially in Mexico, and the financial unraveling of Asia in 1997 started with Thailand. Greece was supposed to be an isolated case in early 2010, but then pressure followed on Ireland, Portugal, Spain and Italy.

Second, there are potential funding issues. In Europe, budget deficits need to be funded - and the main problem is that government finances may not be sustainable when interest rates rise. In some emerging markets, there are budget deficits (e.g., in India and Brazil), but the generally shared characteristic of shaky countries is current account deficits - the country is buying more from the world than it is selling.

Current account deficits are typically financed by capital inflows. As long as investors are happy to pile in because they like a country’s prospects, this works fine. But when markets get jittery, for example because China is slowing down, domestic residents and foreigners take their capital out from many emerging markets and into relative safe havens (like the United States) - meaning that interest rates go up in emerging markets. If this sufficiently undermines economic growth, then prophesies of a slowdown can be self-fulfilling.

Third, the macro policy environment in the United States is not helpful to emerging markets. In part, this is because the Fed is inclining toward a less easy monetary policy and may either raise short-term rates or make statements that push up longer-term interest rates (broadly speaking, this is what has happened since the spring).

In 1982, higher interest rates in the United States raised borrowing costs for Mexico and other emerging markets, contributing to the onset of what became known as the Latin American debt crisis and, for many of the affected, a “lost decade.” And in early 1997 the United States was also tightening monetary policy. Sometimes small changes in global funding can have big consequences on emerging markets.

In addition, heightened uncertainty about United States fiscal policy tends to cause capital to flow to safe havens - paradoxically, including the United States. This is not helpful to emerging markets with current account deficits that need financing.

The transmission mechanism for the spread of crisis is globalized financial markets, which flip from being sensible to crazed at the touch of a few buttons. You can add a wide variety of wild cards that would help unsettle investors under pressure, including the kind of erroneous trades caused by Goldman Sachs’s trading system recently or the unrelated software problem at Nasdaq. We have surely not seen the last crisis involving so-called high-speed trading, in which computers place - by design - huge orders faster than their human overseers can completely control them.

But the underlying issue remains macroeconomics, and the question of whether capital will continue to flow to emerging markets as their economic prospects become somewhat less positive. Bookmark the International Monetary Fund’s July economic growth forecasts and watch for how these are revised down for “developing Asia” and other emerging markets when the latest numbers come out in October. (Or take a look at the I.M.F.’s DataMapper for growth numbers and watch how it changes color as forecasts change.)

At the same time, two positive factors lower the probability of a serious worldwide crisis.

First, the continuing series of fiascos involving major international banks has a positive side: they are forced to be more careful and they are on the defensive relative to regulation. Almost all the big names have been involved in at least one big scandal in the last couple of years, including JPMorgan Chase’s whale-size trading losses; investigations of money laundering at HSBC and Standard Chartered that ended with the banks agreeing to large settlements, and Barclays (and many others) on Libor. Deutsche Bank, UBS, Barclays and others remain under pressure to increase their equity funding (which means, if the pressure is meaningful, they must reduce their debt levels relative to total assets).

Hubris among international bankers is never low, but it is at more moderate levels than seen in 2005-7. And the pressure from regulators remains meaningful; people still remember the collapse of Lehman five years ago. Leverage (debt relative to total assets) in the largest banks is high - and much higher than we should regard as reasonable - but not at the atmospheric levels of 2007. As a result, losses on emerging market investments (or anything else) are less likely to tip major banks immediately into insolvency.

Second, many emerging markets have larger holdings of foreign exchange reserves than in the past, and they are less inclined to squander these reserves on defending a particular value of their exchange rate. To the extent that these countries can allow their currencies to depreciate modestly as capital flows out, they will naturally tend to increase their exports and reduce their imports - thus tending to reduce their current account deficits (and lower their future funding needs).

Watch carefully for developments in Brazil, Indonesia, South Africa and Turkey. How they respond to financial market pressure will be central to what happens next. If they moderate the effects - allowing some depreciation while raising interest rates somewhat - and keep confidence (and growth) at reasonable levels, there will be no wave of emerging market crises.

But when the big international financial companies get their mojo back, it will be a different story. Big crises follow prolonged episodes of exuberance, when people think there are only one-way bets (on emerging markets or anything else), leverage increases substantially and any downturn can quickly become a disaster. All really big crises start with overconfident investors.