How do emerging markets get into trouble? Let me count the ways
This is a repost of a piece I did for Matt Klein’s invaluable stack “The Overshoot” in May, but I just wanted to make it available here as well. Thanks again to Matt for the opportunity. And a happy new year to all.
For those looking for a tl;dr here is the takeaway, which has the benefit of both being a pithy dad joke and drawing on a hardy perennial in any history of EM troubles.
Behind every Argy problem, there is an (r,g) problem.
In other words, behind every EM problem reminiscent of Argentina, there is a problem in the relationship between a country’s nominal growth rate (g) and the interest rate (r) at which it services its debt stock.
There is obviously a large academic literature on the subject, but this will not make that cut. What follows here is a set of observations from someone who has been active in, or at least watching, EM foreign exchange (primarily) and fixed income (to a lesser extent) since the 1997 Baht crisis. Something like the below has also been what I’ve been tweeting or writing about for close to 10 years, and talking about with younger colleagues at different jobs. Of course, it also builds on many conversations I’ve had in real life and online with people who have considerably more expertise than me.
I will try below to set out the different kinds of balance of payments problems that EMs run into; the feedback loops among real activity, financial conditions, and investor perceptions; and some broad generalizations about “things that have worked, at least for the EM in question.” This last point will also hint at the global collective actions problems that lurk beneath the issue.
Original Sin
The most recent iteration of Argentina’s problems, is yet another reminder of one of the oldest versions of the EM crisis—too much debt denominated in a foreign currency. This is “Original Sin” as Barry Eichengreen and Ricardo Haussman dubbed it in this piece, but the problem itself goes back at least a century before then (and yes, Argentina was featured then too).
Why would a government borrow in a foreign currency? The most likely answer is that not enough foreign investors will lend to it in its own currency, and it may not have enough domestic savings. But it may also need foreign currency lending to finance imports. It may not want to borrow at home because domestic interest rates are too high. And in some cases, its monetary history might mean even local investors prefer to purchase debt denominated in the dollar or the euro.
It’s also intuitively clear why this could lead to trouble—borrowing in a currency a country’s central bank cannot produce at will means the country needs access to flows and/or stocks of that foreign currency to service the debt. These could come through export earnings, the sale of domestic assets to foreigners, or fresh overseas borrowing by the public or private sectors. Should these inflows shrink or dry up, the country’s choices (while it still has them) come down to reducing outflows by constricting imports, tightening capital controls, and renegotiating (or simply halting) debt service. Along the way, it will likely experience the r,g problem as growth falls and risk premia rise. Fixing this usually requires some combination of concessional financing, debt relief, and (attempts at) adherence to conditionality that signals to markets that Steps Are Being Taken to improve growth profiles, reduce fiscal and current account deficits, crack down on capital flight etc. If (and often when) the Steps prove insufficient or simply unworkable for a host of political and economic reasons, or the global market environment turns hostile, the country experiences what will be treated (depending on the labeler’s priors) as either an unfortunate relapse or as unhealthy recidivism. (Cf. Argentina).
Plagiarized Sins
This is a familiar script that comes with occasional plot twists. One common one is an attempt to limit foreign currency borrowing while boosting the attractiveness of debt denominated in the domestic currency by pegging it. This expedient falls into the category of solutions that fall afoul of what Nigel Tuffnel and David St. Hubbins famously described as “the fine line between clever and stupid” (Spinal Tap 1984). Concerns about about the credibility and sustainability of the exchange rate regime lead to progressively higher interest rates that eventually prove unsustainable. The Russian default of 1998 is just one example.
Even in the absence of a peg, a country might attempt an implicit guarantee of real value to by linking its debt to either the exchange rate or to inflation. FX-linked debt is typically more toxic for similar reasons as above, though I wonder if one recent expedient suggests a possible limited use-case. In late 2021, Turkey went through waves of internal dollarization (depositors switching from TRY to USD accounts) that fueled sharp TRY weakness. One of the government’s responses was to offer ex-post recompense in TRY to holders of lira accounts to make up for depreciation against USD. The currency then stabilized for many months. The stability did coincide with a period of heightened diplomatic activity as President Erdogan sought to mend fences with the Gulf oil monarchies, who in turn provided backstops to the Turkish financial system. But it may be also be the case that the provision of a backstop in TRY to depositors (a currency that the CBRT can print) somewhat helped to alleviate worries about systemic failure in a banking system with ever-growing liabilities in a currency the CBRT could not print. The external support very likely mattered more, and had things gone wrong, the TRY liabilities of the Turkish state would have exploded. But even so, this is reminder that every multiple equilibria situation (if this counts as one) has an element immortalized in the film Dumb and Dumber—“So you’re saying there’s a chance?
Inflation-linked debt has been another way (and a more benign one than FX-linking) for a country to reassure investors that it intends to make good its liabilities in real terms. The assumption is that once enough policy credibility in the central bank’s inflation-fighting credentials has been gained through this route, a country can do the “grown-up” thing and issue long-dated fixed rate debt in its own currency. Along the way, a country with too much inflation-linked debt might lose the opportunity to benefit from a fall in debt ratios due to a bout of unanticipated inflation (as happened in the US and the Euro area around and after the pandemic). But by construction, a country with too many linkers is trying precisely to achieve that level of credibility.
But high levels of inflation passthrough from a weaker exchange rate can be truly damaging when they trigger an aggressive response by an EM central bank intent on maintaining credibility. Something like this happened in Brazil in 2015, when the real weakened sharply (from about 2.65 to 4.00/USD), pushing domestic inflation above 10% even as the economy suffered a sharp contraction of 3.5%. The slowdown was likely exacerbated by the Brazilian central bank hiking interest rates to 14.25%. Meanwhile, markets began to worry about Brazil’s debt dynamics as the budget deficit ballooned that year, driven almost entirely by the cost of interest payments on a stock of debt of which only a quarter was at fixed-rates, with the rest being FX, inflation-linked or floating rate debt. I remember reading a note (perhaps by Citibank) referring to the country being a classic case of unpleasant monetary arithmetic and fielding questions about the likelihood of a default on domestic debt. There may be a case that outright fiscal dominance (i.e., a central bank that assures sovereign debt sustainability through its interest rate policies) is better for debt dynamics. This is partly the case in Turkey, where the famously complaisant CBRT has helped keep debt to GDP at under 40%. Unfortunately, low interest rates and a weak lira are less good for a banking sector substantially indebted in dollars.
I thought this was The Good Place!!!
The cautionary tales above suggest that the final destination for EMs should be the ability to draw foreign investors into domestic currency debt markets via long-dated fixed rate bonds without any need for gimmicks like indexation. In theory, this should be the promised land for EM, with the foreign investor bearing the currency risk.
Alas, that is not always the case either. Local-currency debt markets can also see dramatic outflows by foreign investors (or their underlying holders) purely in response to currency weakness. One of the reasons foreign investors in local currency debt might be skittish is that while they might have relieved the borrowing country from the burden of an asset-liability mismatch, they might have taken one on themselves. After all, their own liabilities are likely to be in dollars or euros, as are their own investors’ liability chains. And for all that local currency borrowing might in theory reduce default risk, defaults are rare anyway, and perhaps running that rarer risk is preferable in the psyche of the underlying investor to watching persistent mark-to-market losses on local currency positions in dollar terms. And since current-account deficit emerging markets tend to have higher front-end interest rates than the developed markets that generate their inflows, local currency investments into EM are less likely to be currency-hedged, meaning that capital that has flowed downhill ends up flowing uphill even faster in moments of stress. This is a phenomenon dubbed Original Sin Redux in a recent paper (though I think Sequel Sin would have been snappier).
What might make investors want to stick around in a local currency market in the face of such herding behavior? I think one handy rule of thumb follows from a basic question—does a weakening of the exchange rate in a downturn translate into a loosening or a tightening of financial conditions? The amount of foreign currency debt owed by a country’s government is an obvious marker of impending trouble. But the country will face similar issues if its private sector has gone an overseas borrowing binge, unmatched by a parallel buildup of liquid foreign assets in its public sector. A reserve drawdown of roughly 1 trillion USD in 2015/16 helped China unwind a very large short-dollar position in its private sector, and a similar approach to precautionary accumulation seems to form part of the Reserve Bank of India’s toolkit. Trouble will also follow if too large a portion of the domestic debt stock is held by overseas investors sensitive to currency risk. Other red flags include very high passthrough into domestic inflation, a tradable sector either too small or tool poorly equipped to pick up global market share from competitors as a result of currency weakness, or a high propensity to capital flight when confronted with exchange rate weakness.
The litany of enumerated risks can be easily matched with real-life cautionary stories. Commodity exporters (with Argentina again taking pride of place) suffer from a higher proportion of total debt stock being in FX, and a vulnerability to cyclical, terms of trade, or financial shocks that originate outside their own economies. And sometimes they get hit with more than one shock at a time as happened in 2014-16—USD strength, a China slowdown, and the oil price collapse that stemmed from shale-OPEC battles.
It is, but only for some people
But why do these issues not affect Australia or New Zealand—places that have a similar trade profile, and yet manage to issue very large amounts of local debt cheerfully held by foreign investors through huge swings in currency cycles. History and politics are likely the answer. New Zealand invented inflation targeting in response to a problem that was bad by developed markets standards but that is nothing like experiencing price rises at a rate of thousand or millions of percent a year or repeating stabilization strategies associated with a brand new name for the currency —Australs, Cruzeiros, Reais etc. The market’s reaction to protests in Chile in 2019-2020 also suggest that investors can be skittish about fiscal expansion even at low government debt levels if they fear political change —with a Gini coefficient around 60, the country is one of the most unequal members of the OECD. Investors in the region seem to have a muscle memory of domestic capital flight and the use of inflation as a nominal mechanism to satisfy contested claims on output shares.
Conversely, many EM professionals tend to think better of export-manufacturing-led, reserve accumulating East Asia; an India whose government debt market is relatively closed to global financial flows, and Central and Eastern European members of the EU as being safer on these counts. And it may be useful to think of that safety as coming in the form of shock absorbers, whether real or financial.
This can take the form of a large buildup of precautionary reserves to balance or offset private sector external borrowing. It could also result from a strategy of engagement with the global economy that primarily seeks inbound direct investment, which in turn offers four benefits— a transfer of technology, upstream and downstream multipliers, export earnings, and a lower place in the domestic capital structure with floating (dividend) rather than fixed service costs. This describes a lot of the Asian success stories. The success stories in Europe are mainly the ex-Comecon members of the EU who have benefited from inbound FDI. But unlike the big Asian reserve accumulators, they are also deficit economies very open to foreign portfolio capital. This has undoubtedly led to hiccups (especially in 2007-08), but with much of their inbound investment coming from more developed EU members, they at least have shared exposures to the same broader real and financial cycles. And they also have real shock absorbers — that other EMs don’t— in the form of large flows of infrastructure, pandemic and adjustment funds, agricultural subsidies and free labor movement inside the EU.
The good news is that East and Southeast Asia and India account together for a very sizable portion of the developing world’s population. And for all the occasional political sputtering, the EU’s strategy for its central, eastern, and south central (Balkan) EM members will (at least in my view) continue to support economic development. The bad news is that with the likely exception of Mexico —potentially a big beneficiary of the IRA and other US efforts at derisking/decoupling/friendshoring or whatever one calls it — very large portions of the EM universe are likely to stay stuck in the negative feedback loops of real, economic, and financial shocks laid out above.