According to an old Wall Street saying, when the winds are strong even turkeys can fly.
By this it is meant that when financial markets are buoyant, even countries with very poor economic fundamentals will be able to borrow freely at low interest rates. The saying also implies that when world market liquidity conditions begin to tighten, those countries with weak fundamentals come crashing down to earth, leaving their creditors high and dry.
This Wall Street teaching is relevant today when global liquidity conditions have never been easier and when, following the pandemic, the emerging market countries were able to borrow on easier terms than before despite their rapidly deteriorating economic fundamentals.
The saying has particular significance today considering that the emerging market economies now account for around half of the world economy. As such, if earlier emerging market debt crises caused world financial market trouble, how much more trouble could they cause today when many of these economies have weak debt fundamentals and when they now constitute a much larger part of the world economy than they did before?
Today, the global financial market winds for the emerging market economies have never been stronger. One indication of these powerful winds is the fact that a record $18 trillion of global bonds now bear negative interest rates. Another is the very rapid rate at which the world’s central banks are expanding their balance sheets. Whereas it took former Federal Reserve Chairman Ben Bernanke seven years to increase the Federal Reserve’s balance sheet size by $3.5 trillion, since the start of the pandemic it has taken current Fed Chairman Jay Powell less than six months to do the same thing.
In the initial phase of the pandemic, the emerging market economies experienced a record withdrawal of capital. This occurred as investors fretted about the perfect economic storm that the COVID-19 pandemic was visiting on those economies at a time when they were already heavily indebted. Not only were those economies having to deal with a once-in-a-century health crisis. They also had to contend with plunging international commodity prices and rapidly contracting overseas export markets.
In response to the pandemic, the world’s main central banks opened the monetary spigots, driving down interest rates and forcing investors to stretch for yield. As a result, capital flowed back strongly to the emerging market economies. Even those countries with the most compromised public finances had little trouble raising money on highly favorable terms.
According to the International Institute of Finance, the emerging market economies borrowed almost $900 billion abroad in 2020 and another $100 billion in January 2021. Equally striking is that they managed to do so at close to record low interest rates.
In pouring money back into the emerging market economies at record rates, investors do not seem to be bothered by the severe economic damage that the pandemic has visited on these economies. According to the International Monetary Fund (IMF), these economies have suffered by far their worst economic recession in the post-war period. This has caused the average budget deficit for these economies to rise to 10 percent of GDP and their public debt to skyrocket to record levels.
The emerging markets’ deep economic recession and troubling debt level has raised alarm bells at the World Bank. Indeed, the Bank’s chief economist is now warning that it is only a matter of time before we see a major wave of emerging market debt rescheduling and restructurings that could pose a challenge to the world financial system.
With the Biden administration planning another staggeringly large budget stimulus, we cannot be far from the beginning of a new increased U.S. interest rate cycle. Past painful experience, including that of the 2013 taper tantrum, suggests that when that happens the presently highflying emerging market economies will come crashing down. That in turn is bound to cause strain to the financial system.
One hopes that the Biden administration is already making contingency plans for such an eventuality and is standing ready to lead an international effort to contain the fallout from such a crisis to the rest of the world economy.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.