Emerging markets have found themselves in hard times. Economic growth has slowed and their currencies have been getting walloped.
With everything that’s going on Morgan Stanley’s Manoj Pradhan identifies “the seven deadly” characteristics of past emerging market crises.
- A sudden stop – This is a “severe slowdown or an outright reversal of capital inflows that ultimately leads to a loss of access to funding markets, creating a severe economic downturn even if there is no outright default.” This can be caused by excessive real exchange rate appreciation, non-performing loans shrinking banks’ balance sheets, uncertain elections and so on.
- It spreads – Irrespective of which sector or part of the economy the ‘sudden stop’ begins, it spreads into other areas.
- The sell-off is quick – “Market moves far outstrip fundamentals. Disorderly sell-offs are naturally about capital protection as investors (domestic and foreign) move capital out of the way and demand a risk premium for re-engaging. However, the speed is also the market’s way of forcing a rapid resolution of the underlying macroeconomic problem – a process that would otherwise take a lot longer.”
- The scale of the sell-off is related to the size of the adjustment needed to solve the problem – “Whether the underlying problem actually gets resolved over the longer period of adjustment …is irrelevant as the crisis unfolds (just look at the uncertainty about the future of Europe even though the peak of the crisis is most likely behind us).”
- The sell-off can cause currency weakness or a fall in various domestic assets – This depends on a few different things like how much the banking system has suffered, or how much the currency had appreciated in real-terms before the crisis kicked in. Major distortions make it harder for the central bank to raise rates and support the currency because it will “damage the banking system.”
- There is contagion risk – The crisis spreads from the “weakest link” to other “vulnerable economies.”
- Economies can be shut out of funding markets – “A full-blown sudden stop sees economies lose access to funding markets for a period of more than six months. Economies that are exposed but not vulnerable tend to be shut out from funding markets for only a brief period of time.”