Opinions - 10.02.2014 - 00:00
Investors – mainly retail Investors – are pulling billions of dollars out several high profile emerging markets. As usual, this market volatility has triggered a blame game with, amongst others, the Indian central bank governor declaring that international monetary cooperation had broken down (as if it had ever started, but that’s another matter!) Others retort that “weak fundamentals” are the reason why some emerging markets can’t cope with the unwinding of the U.S. Federal Reserve Board’s third attempt at Quantitative Easing.
This note isn’t about the blame game but about another feature of these bouts of emerging market turmoil – namely, the huge outpouring of advice of what developing countries should do. Very little of that advice ever gets followed and I want to explain why. “The best way to ensure that foreign investors remain interested – and invested – in those countries is to implement reforms needed to maintain economic dynamism.” That’s how the Financial Times concluded its editorial on Saturday concluded its assessment of recent emerging market turmoil. Is the advice just wrong?
Now, some economists are really interested in the question of what’s the right thing for countries to do when investors lose faith. I understand that, but for me having been a World Bank official, an interesting question is why again and again such advice has such little impact? Inevitably, as an economist, I think of incentives. So what’s the incentive for policymakers to do the right thing?
Recently Gavyn Davies neatly summarised the party that has been going on for years in several of the larger emerging markets. Credit bubbles, housing market bubbles, commodity market-driven booms – we’ve seen this film before and we know how it ends. He rightly points out that the risk of a “sudden stop” of capital inflows will induce sharp economic downturns. For sure, reserves are higher now than in the 1990s and more countries have flexible exchange rate regimes. But will governments use these shock absorbers? To coin a phrase, is this time really different?
A mile in their shoes
Before you lecture policymakers in developing countries, put yourself in their shoes. I’m asking you to do this not to make excuses but because you might see things differently. First, many of the weaknesses of the EMs that analysts are worrying about now aren’t new, yet for years domestic and foreign investors overlooked them. Even the US Federal Reserve Board’s “tapering” has been signalled for some time.
Sceptical officials might wonder that criticisms now being levelled by investors are nothing more than ex-post rationalisations, while instead what’s really happening is a good old fashioned panic. Panics happen well investors try to second guess other Investors – that is, they sell because they expect other investors to sell. In a panic policy announcements only work if they shift expectations and officials may decide that fear-driven expectations are hard to budge.
Second, the more officials’ sense that noise in investor sentiment overwhelms the signal (responsiveness to fundamentals) the less attractive are taking painful policy measures now. Worse, to the extent that sharp policy moves before the music stops are seen as officials panicking and politically unsustainable, then all that’s left are baby steps and they are unlikely to impress. Officials may conclude they are “damned if you do, damned if you don’t” – providing a rationalisation for inaction. Rather than try to influence the markets now, in essence officials may decide they have more leverage when clearing up the mess after a sudden stop.
Third, to the extent that poor fundamentals highlighted by investors reflect deeply entrenched characteristics – corruption, not-so-independent central banks – then officials know that investors won’t be convinced unless there is some profound shift in domestic politics. But what will trigger that? Why will entrenched interested suddenly surrender or be overwhelmed? Of course they won’t. Officials might reckon that investors have, in effect, set the bar too high.
Turmoil equals stalling
For all these reasons don’t expect policy to stop the sudden stops. For sure, once government start picking up the pieces after footloose investors have fled, policy decisions taken then may have significant implications for who bears losses and for where the future investment opportunities are – matters which smart investors will no doubt follow. Indeed, the leverage policy has here is much greater than with often-recommended structural reforms. Those reforms may have a beneficial effect on growth but only after many years – consequently, the contingent, delayed impact of structural reforms makes them of little immediate relevance to investors.
It’s not hard, then, to rationalise stalling by governments during market turmoil. Barring some external shock, policy won’t stop train wrecks in the vulnerable emerging markets. 2014 won’t be boring.
An abbreviated version of this blog was published on the website of the "Financial Times".
Picture: Photocase / Marc Walter
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