I visited Korea earlier this summer and gave a talk on effects of U.S. Tapering on Emerging Markets. (This was also the subject of comments at an Istanbul conference sponsored by the NBER and the Central Bank of Turkey in June.)
An interview on the effects of policy at the Fed and other advanced-country central banks on East Asian EMs now appears in KRX magazine (in Korean), August. Here is the English version:
Special Interview with Jeffrey A. Frankel <KRX MAGAZINE> August
Q: On 10 June 2014, Federal Reserve Bank of Boston President Eric Rosengren said in a speech that the Fed’s “new” monetary policy tools, including forward guidance and large-scale asset purchases, were “essential” in ensuring the economic recovery in the United States. What do you think about the ‘ongoing’ U.S’s ‘Tapering’ policy? And what is your idea about appropriate “new” monetary policy?
There is a danger that some investors will lose sight of the purpose of a benchmark index. The benchmark exists to represent the views of the median investor dollar. For many investors, going with the benchmark is a good guideline – especially those who recognize themselves to be relatively unsophisticated and also those who think they are sophisticated but really aren’t. This is the implication of the Efficient Markets Hypothesis (EMH), for example.
The Obama Recovery. The U.S. economy was in free fall in late 2008, whether measured by GDP statistics, the monthly jobs numbers, or inter-bank spreads. Was the end of the recession in mid-2009 attributable to policies adopted by President Obama? A full evaluation of that question to economists’ standards would require delving into the complexity of mathematical models. The public generally has a simpler standard: was the impact big enough to be visible to the naked eye? Amazingly, the answer is “yes.” Whichever of those statistics one looks at, and whether it is coincidence or not: the economic free-fall ended almost precisely the month that Obama took office, January 2009.
Emerging markets have generally had much better economic fundamentals over the last decade than advanced economies. For example, one third of developing countries have succeeded in breaking the historical syndrome of procyclical (destabilizing) fiscal policy. For the first time, they took advantage of the boom of 2003-08 to strengthen their budget balances, which allowed a fiscal easing when the global recession hit in 2008-09.
The 15-year cycle in EMs. Market swings that start out based firmly on fundamentals can eventually go too far. Some emerging markets like Turkey look vulnerable this year. A crash would fit the biblical pattern: seven fat years, followed by seven lean years. Here are the last three cycles of capital flows to developing countries:
1975-81: 7 fat years (“recycling petrodollars”)
1982: crash (the international debt crisis)
1983-1989: 7 lean years (the “Lost Decade” in Latin America)
1990-1996: 7 fat years (Emerging Market boom)
1997: crash (the East Asia crisis)
1997-2003: 7 lean years (currency crises spread globally)
Emerging markets have performed amazingly well over the last seven years. They have outperformed the advanced industrialized countries in terms of economic growth, debt-to-GDP ratios, and countercyclical fiscal policy. Many now receive better assessments by rating agencies and financial markets than some of the advanced economies.
As 2012 begins, however, emerging markets may be due for a correction, triggered by a new wave of “risk off” behavior among investors. Will China experience a hard landing? Will a decline in commodity prices hit Latin America? Will the sovereign-debt woes of the European periphery spread to neighbors such as Turkey in a new “Aegean crisis”?
After the currency crises of 1994-2001, and especially the East Asia crises of 1997-98, a lot of research investigated what countries could do to protect themselves against a future repeat. More importantly, policy makers in emerging markets took some serious measures. Some countries abandoned exchange rate targets and began to float. Many accumulated high levels of foreign exchange reserves. Many moved away from dollar-denominated debt, toward other kinds of capital inflow that would be less vulnerable to currency mismatch, such as domestic currency debt or Foreign Direct Investment. Some instituted Collective Action Clauses in their debt contracts to facilitate otherwise-messy restructuring of debt in the event of a severe negative shock. A few raised reserve requirements or otherwise tightened prudential banking regulations (clearly not enough, in retrospect). And so on.
In 2008, the global financial system was grievously infected by so-called toxic assets originating in the United States. As a result of the crisis, many have asked what fundamental rethinking will be necessary to save macroeconomic theory. Some answers may lie with models that have in the past been applied to fit the realities of emerging markets — models that are at home with the financial market imperfections that have now unexpectedly turned up in industrialized countries.The imperfections include default risk, asymmetric information, incentive incompatibility, procyclicality of capital flows, procyclicality of fiscal policy, imperfect property rights, and other flawed institutions. To be sure, many of these theories had been first constructed in the context of industrialized economies, but they had not become mainstream there. Only in the context of less advanced economies were the imperfections undeniable. There the models thrived.