Donald Markwardt
Senior Research Analyst, International Finance and Macroeconomics Research
Capital Flows and Systemic Risk
Donald Markwardt is a senior research analyst in international finance and macroeconomics at the Milken Institute. He studies topics relating to systemic risk, capital flows and investment. Concentrating on systemic risk assessment in the financial system, his recent work focuses on liquidity and financial stability in the asset management industry.
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More maturity, less anxiety in emerging markets
By: Donald Markwardt
April 03, 2014
Emerging markets have been featured prominently in the headlines over the past year, and not in a good way. Since last spring, when the Federal Reserve startled investors by announcing an earlier reduction of monetary stimulus than expected, emerging market economies have been hit by bouts of rapid currency depreciation, falling asset prices, and investment capital flight. This year alone, we have seen troubling developments in some EMs, especially the currency meltdown in Argentina, weaker economic data in China, and most recently Ukraine, where geopolitical turmoil threatens trade, investment, and security in the region.

Some prognosticators have interpreted these events as signs of worse things to come. They predict a return of the full-fledged crisis conditions that imperiled developing countries in the 1990s, setting back their prospects for economic growth. As we note in our recent Current Views report, "Emerging Markets: Temporary Turbulence, Long-Term Resilience," these predictions are sure to grab attention but unlikely to come to pass.

For one thing, many countries appear to have learned lessons from the past. Emerging market crashes in the 1990s were characterized by debt defaults or restructurings, brought on mainly by borrowing too much in foreign currencies and operating under fixed currency regimes without sufficient reserves for periods of duress. Since then, numerous EMs have expanded their reserves, let their currencies float, and borrowed in their domestic currencies. Emerging Asia's local currency bond markets, for example, have grown more than 40-fold since 1998.

Besides facilitating growth in good times, the development of alternative capital markets like these can help developing nations avoid overreliance on bank financing, another staple of the crisis period that was devastating to businesses and national economies. Larger businesses can now access funding through equity and bond markets, which can act as a "spare tire" during a banking crisis. In fact, these markets have been so successful that EM corporate debt as a percentage of GDP has reached record highs in some countries, notably China. This could be viewed as a warning sign of excessive leverage, but it's worth noting that debt levels are still below those in developed markets. Emerging market corporations also have strong cash balances, representing 30 percent of total debt and enough to service roughly 30 months of debt payments.

While a repeat of the rocky times of the 1990s appears unlikely, there are still risks to be heeded. Additional spells of volatility in asset prices and investment flows are to be expected, especially in the wake of the March FOMC meeting, when the Fed announced it would move away from its unemployment and inflation thresholds for raising interest rates. This increases the uncertainty around Federal Reserve action, and historically, rising rates have stifled investment in emerging markets.

Retail investors have fled emerging market assets en masse, but institutional investors like pension and sovereign wealth funds have been more discriminating. They're still showing strong demand for investment opportunities in countries with solid fundamentals, but perhaps lacking in policy decisiveness. Mexico's recent energy reform bill to break up its state-owned oil and gas monopoly is a good example of the kind of structural reforms governments can take to spur private investment.

A recent post by Institute Senior Fellow Komal Sri-Kumar highlighted the unpopular decision by India's central bank to raise interest rates to control inflation, another example of the kind of policy measures that strengthen confidence among investors and enhance prospects for long-term growth. If emerging market countries take more steps like these, they can expand access to more stable sources of capital and make them more able to move forward, rather than back to bad times.