Capital flight from emerging markets has been accelerating in recent weeks ($6 billion alone in the week ending February 5). Turkey is the poster child, but the exodus is also happening in India, Indonesia, Brazil, South Africa and others – mostly from equity markets. This “hot money” is moving out over concerns that asset bubbles have built up, and that emerging market economic growth is now slowing. The slowdown is partly a result of tighter money in the wake of the Fed’s tapering plans and a decelerating economy in China, many believe. To better understand the risks to the global financial system, Knowledge at Wharton spoke with Wharton finance professor Franklin Allen in this podcast.
An edited transcript of the conversation follows.
Knowledge at Wharton: To give a bit of context, there has been a lot of capital flight out of emerging markets in recent weeks. Turkey is the poster child, but it is also happening in countries such as India, Indonesia, Brazil and South Africa. For a long time, strong economic growth in emerging markets kept that money flowing in. Now, those growth prospects — relative to the more developed countries — look to be sagging, and that money is starting to rush out. And with financial liberalization, that often means there are fewer capital controls to prevent it from leaving quickly.
Some emerging market central banks are responding by raising interest rates to try and keep the money in. Of course, that has a big downside: Higher rates make it tougher for businesses to get loans. And so far, those higher interest rates do not seem to be doing much to keep it in. This is mostly equity money leaving at this point. Eventually, that could bleed into debt issues.
All of this is partly a response [many observers say] to the Fed’s aim to tighten the money supply — to taper quantitative easing — and also to the slowdown in China, which could affect emerging markets very heavily. Is this the dynamic that you see out there? And, if so, what is causing it in your view? And how far along in the process do you think we are?
Franklin Allen: I think it is important to start with a somewhat broader view of what is happening. What happened over the last few years is that a lot of money went from low interest rate countries — particularly the U.S., but also from Europe and Japan and other places — to the emerging markets. These are the so-called carry trades that we have heard so much about. And they basically distorted a lot of asset prices in those countries. Just to take one example, if you look at what has happened to real estate prices in Brazil, they have rocketed the last two or three years. And yet that does not seem to be the result of how well Brazil is doing because actually they have had problems because the money flowing in has pushed up the exchange rate and made it difficult for Brazilian manufacturers, for example, to compete. Brazil has actually had fairly slow growth.
“There is a sense in which the global governance mechanism for financial affairs does not work well because the emerging countries are so excluded from it.”
I think this is all a part of what many people have worried about, which is there have been what people loosely call asset price bubbles. Now that things are tightening up, what we are beginning to see is some withdrawal, some worrying about whether prices are correct or not. And this is the start of a process, which will certainly — to some degree at least –continue in the emerging countries, but will also gradually spread to other assets as we go further and further into tapering, and then eventually have interest rates start to rise.
Knowledge at Wharton: Do you think this is essentially a cyclical thing and that it is going to end up being an orderly take down — a natural process — for financial assets to flow back and forth to where they get the highest return?
Allen: No, I do not think that this is cyclical, although there is obviously a part of it that is…. We have had asset prices distorted by, what is now many years of these low interest rates. And the notion was, well, the emerging countries should be able to sterilize the inflows and deal with them, but in fact it is very difficult to do. These rises in asset prices, particularly real estate in many countries, if they are reversed it is going to cause financial stability problems in the same way we had in the U.S., Spain and Ireland. I think that those are the dangers. The trouble is we do not really know what asset prices should be because we have had these very easy money policies for so long now.
Knowledge at Wharton: For these countries I guess the danger is that they try to raise interest rates to prevent capital leaving so fast. That hurts their economy further. I suppose there is a danger of a run on their currencies similar to the kinds of things that happened during the Asian financial crisis [in the late 1990s]. Not to say that it is at that stage, or necessarily even heading there, but the dynamic seems to be similar. And then, of course, once the markets start to raid one country, then they start to look at who the next victim is and you get this domino effect. How big of a risk is that kind of thing? And could you just talk about what those risks look like right now?
Allen: Well, again, I think there are financial stability risks as you raise interest rates. And Turkey raised them a lot, but other countries raised them varying amounts. But as you start seeing big raises in interest rates, long-term assets are going to fall in price. And, if it is real estate and the banks lend against that real estate, then that causes problems in the banks.
All of these things accumulate and people starting to wonder whether they should get their money out now. And then that creates the dynamic, which you just described, that they are going to expect further falls and we get into these very bad self-fulfilling prophecies…. I think we are still some way away from that, but we have only just started tapering. We aren’t even at the start of any of the developed countries really raising interest rates. And I think we still have a tremendously long way to go before we get back to some kind of normality where we do not have this very easy money in so many countries.
Knowledge at Wharton: Partly what is happening is that financial markets have become so globalized that, of course, they are interacting more than ever. The Fed tapers a little bit and you seem immediately to get results in some of these countries that investors worry may not be able to keep up the returns that they have been getting.
And, yet, there does not seem to be any one country, or any body, that has control over it. It is a real network without any real dominant player. The U.S. is obviously affecting a lot of things, but if this starts to slide out of control who is in charge? Is there anyone in charge? What could be done? Is there something the U.S. can do? Europe? Do they have an interest in this? Or will we have to sit back and watch a mini or maxi Asian financial crisis all over again?
Allen: I think it will be somewhat different than [back] then because there were these severe problems of them having borrowed too much — the firms and banks — in foreign currencies, and the unwinding of that was very unwieldy. Now, fortunately, we have central bank swaps as a way of countering that. Now, the big problem with that is that they did this arrangement [and] they kept China out of that. And I think they should not have done that. They should have had China included. But that is a big antidote for the kinds of very serious problems we had in a global sense.
But I do think that there is a breakdown in monetary coordination. Raghuram Rajan [governor of the Reserve Bank of India, and former chief economic adviser to India’s Ministry of Finance and chief economist at the International Monetary Fund] was complaining about this a few days ago. There is a sense in which the global governance mechanism for financial affairs does not work well because the emerging countries are so excluded from it.
And so when they face problems, there is not a good way of trying to solve them, I would say, because the IMF is dominated by the Americans and the Europeans. And then we have this awkward switching back and forth between the G7, G8 and the G20. And it is never quite clear which group is in control. Because the G7 and G8 do not include China or any of these countries like Brazil or India and so on, even though they have massive economies. The G20 does, but they do not really seem to be able to make decisions with so many people around the table so to speak. We do not have a good governance mechanism at the moment to deal with these kinds of issues….
“If countries get in to trouble, rather than going to the IMF … they may just go straight to the Peoples Bank of China and ask for loans from them.”
Knowledge at Wharton: A lot the countries that we are talking about here are in Asia. So one thinks back to the Asian financial crisis and you mentioned some similarities and differences. A lot of those countries have more foreign currency reserves then they did back then, so, they would not be quite so vulnerable to runs on the currency as they once were. Also, the swap mechanism that you mentioned, could you just describe the mechanics of that in simple terms? Is that the central bank swapping assets to balance out where currencies values are?
Allen: The basic idea is, if you have, for example, Korean banks that have liabilities in dollars, they will need to get ahold of dollars. And it may be difficult for them to do that if the markets are in turmoil. Central bank swaps allow for the Fed to provide dollars to the Bank of Korea, which provides some collateral for that. And then the Bank of Korea can lend to its banks in dollars and take on the credit risk. That was a very successful mechanism in the recent financial crisis and it is one of the reasons we did not have stresses of the kind we had in the Asian financial crisis. So that is a big positive.
I think the other big factor is China, because China has these massive foreign exchange reserves. They have $3.66 trillion dollars now. And one of the things that we may start seeing is that, if countries get in to trouble, rather than going to the IMF or some of the other more traditional institutions, they may just go straight to the Peoples Bank of China and ask for loans from them. Now that may in itself lead to some issues about how they get hold of those dollars and so on, but I think we may see some interesting dynamics, which we have not seen before — both politically and economically.
Knowledge at Wharton: Can you discuss which countries are most vulnerable when it comes to their banking systems? And also, given that in places like Europe and the U.S., the banks are probably heavily invested in those countries, what is the potential blow back to them? I am thinking of Europe in particular.
Allen: Clearly there are a lot of cross border flows…. This is the financial stability problem. If you look at countries that have had big real estate booms — and many of them had one — those asset prices may fall significantly. We may see loans go bad and so on. And many of these countries have not only economic problems, but they have political problems. [For example,] in Turkey and Thailand — and India is just about to have a big election — there are a lot of political issues in addition [to economic challenges.]. So that puts the whole system under stress.
Which are the countries with the worst situation? I think it is difficult to say without a very detailed examination. This is not like Europe, where we are going to see an asset quality review this year. It is difficult to predict exactly where the problems will be — but I think it is the countries which have a combination of economic and political problems that will tend to see problems, if they occur. It is not certain that they will occur. Maybe the asset prices have not been that distorted and things will be fine. That certainly seems to be what many market participants and many people in the official sector believe.
Knowledge at Wharton: Maybe a good way to put this whole thing in perspective is to let me ask you to provide what you see as the best case, middle case and worst case scenarios. And could you give some kind of a percentage weighting to each?
Allen: The best-case scenario is that things quiet down. Tapering goes ahead. The Chinese economy does not slow down significantly. They have no problems in the shadow banking system. Interest rates start to rise maybe in a few quarters’ time. That happens slowly over a long period and there are no financial stability problems anywhere. I think that is the rosy scenario. I think that is what the official sector is hoping for.
“There is a huge range of possibilities out there, and I think the real problem is that nobody really quite knows how it is going to play out.”
The moderate scenario is we have a bumpy ride and we see more of these kinds of events that we have seen in the last few days and weeks. But we do not see anything particularly catastrophic. Maybe a few countries have severe problems. Maybe somewhere, like Turkey or Brazil, has a serious problem. But, by and large, we do not have a worldwide sort of financial stability problem.
The worst-case scenario is that asset prices are badly distorted. We see big adjustments and then we see overshooting because of some of the self-fulfilling kinds of prophecies that people start anticipating. Exchange rates are going to go down below what would be the long-run rates … and we have a lot of turmoil and a lot of financial stability issues. And maybe that it is worse than what happened in Asia because it is not just an Asian problem. It becomes a global problem and it feeds back between the emerging world and the developed world.
Now what are the probabilities on those? Well, hopefully the last scenario is not very probable, but it is not zero either. I think it is probably 10% or 15% — something like that. And then I would say the moderate scenario with some bumpiness and maybe some countries getting into trouble and so on, that is probably fairly likely with a wide range of possibilities. And that is probably maybe 50%-60%. And then I think the good scenario is probably the remainder, which would be 25%-30%, depending on how we fix the [probabilities] on the other two. But there is a huge range of possibilities out there, and I think the real problem is that nobody really quite knows how it is going to play out.
Knowledge at Wharton: And then there is always the risk that things just happen too fast. Even if authorities know the right thing to do, or think they know the right thing to do, and want to do the right thing, the markets are just moving at a lightning fast speed and they can’t get ahead of it.
Allen: Right. And that would be part of the worst-case scenario. They simply lose control.
Knowledge at Wharton: What do you think our listeners should understand about conditions in emerging markets right now that is not coming through so clearly in the mainstream business press?
Allen: We hear a lot about asset prices bubbles and so on, but there is not much of a discussion of, if that actually has been happening, what does it mean? How is it going to play out? And I think that that’s the thing that’s missing from the business press — a discussion of what the alternative way of thinking about these issues is. If you go back to the crisis of 2007, there is no official narrative of exactly what happened other than that some people — in the U.S. for example — would argue that it was a problem in the mortgage market. But that’s not what happened in Spain or Ireland. What we saw was asset prices were simply way out of line. When they adjusted, it caused these big problems and that created even more problems.
The big issue now is have we done the same thing again? And I do not think that is being discussed in a serious way. People still think about the world very much in terms of standard macroeconomic models, but we seem to be in a very different world than that and financial stability is at the center. The distortion of asset prices through central bank monetary policies and so forth is something we do not have much understanding of, although it seems to be at the heart of what happened in 2007 and 2008.
I think what is missing is a discussion of where we are at in that process. Does it really make that much sense that the stock market went up 30% last year? Why did real estate prices in Brazil double in Sao Paolo and Rio de Janeiro in a couple of years? What exactly is happening here and what is going to happen as we unwind and try to get back to some kind of normality in terms of interest rates?
Knowledge at Wharton: Given all the players and the complexity, what do you think is the most likely thing? Is it that we muddle along until there is a big problem? Or is there enough understanding and forethought going into this to start to provide some kind of a more orderly unwinding? What do you see happening? And what do you see happening going forward?
Allen: Well as we were discussing with the scenarios, I think there is sort of a good chance — maybe 50%-60% — that we have a bumpy ride but we do not have any catastrophes….
Hopefully that will be the worst that will happen. But we do have the worst-case scenario there. That is a possibility. I think that the comments that you made in your question about things happening at lightning speed — that can all easily play out. There is a lot of money that can move around very, very quickly. And these are very difficult calls to make on how to invest the funds. Things can change dramatically with these kinds of foreign exchange reserves, cross border flows and so on. We have not really seen these kinds of orders or magnitude of flow internationally before, I would say.