Emerging market prospects
The prognosis for emerging markets recovering from the financial crises of the past few years is guardedly hopeful. At the same time, developments in industrial country financial markets, especially the United States, bear close watching; the private sector can and should play an active role in crisis prevention and resolution; and improved information flows to the market from reliable and impartial sources, like the IMF, are of vital importance. These were some of the themes pursued in a recent IMF Institute seminar, featuring former IMF staff members who now head economic analysis units for leading investment banks and funds. The panel included Bijan B. Aghevli, formerly Deputy Director in the IMF’s Asia and Pacific Department and currently Director of Asia Economic and Policy Research for Chase-Manhattan Bank; Mohamed A. El-Erian, formerly Deputy Director of the IMF’s Middle East Department and currently Managing Director, Pacific Investment Management Company; and Mahmood Pradhan, formerly Senior Economist in the Asia and Pacific Department and currently Chief Emerging Markets Economist with Tudor Proprietary Trading.
Recovery in Asia and prospects for Japan
Describing the situation in Asia as “smooth sailing now, but still rough seas to navigate,” Bijan Aghevli said the Asian crisis countries had turned the corner earlier than forecasters had predicted. Although the economies were recovering at different rates, all were doing well. Three factors lay behind this strong resurgence, Aghevli said: stimulative policies, a turnaround in market sentiment, and the synergistic relationship among the countries.
Stimulative policies. All the countries included in his survey (China, Hong Kong SAR, Indonesia, Malaysia, the Philippines, Korea, and Thailand) went into the crisis with a strong fiscal position, low levels of domestic debt, and low inflation. Thus, the heavy deficits they incurred during the crisis were manageable, while weak domestic demand and a regionwide fall in commodity prices kept inflation down. Fiscal policy has supported the recovery, but at the cost of rapidly deteriorating fiscal positions, Aghevli said. The authorities’ tightening of monetary policy—as a first and necessary line of defense against assaults on the domestic currency—has since been relaxed. With exchange rates stabilizing, interest rates have now fallen sharply to precrisis levels, although they remain relatively high. Coupled with considerable excess capacity and little or no inflation, these interest rates could cause problems. At the same time, real exchange rates remain substantially depreciated relative to precrisis levels, giving rise to concerns about competitiveness. On the brighter side, all crisis countries have rebuilt their reserves to comfortable levels sufficient to cover short-term debt.
Market sentiment. The crisis-propelled deterioration in market sentiment prompted a shift from consumption to saving, which played a large part in restoring confidence. By 1998, Aghevli said, equity prices in Asian markets had risen beyond precrisis levels, while bond spreads, although higher than before the crisis, have narrowed.
Synergy. The simultaneous recovery in all countries created strong synergies among them, leading to even stronger growth in the market for Asian exports, a trend that Aghevli said is expected to continue into 2000.
Growth may slow in the medium term, however, Aghevli warned, since the recovery is cyclical rather than structural, and output levels are still well below potential. Countries that implement strong structural reform, he said, will probably grow faster than those that lag behind.
Although it is not clear that Japan has reached the turning point, Aghevli said he was bullish (or, at least “less bearish”) on the country’s prospects. As with the other recovering Asian economies, Japan has implemented supportive fiscal and monetary policy, although market sentiment remains lukewarm. Nevertheless, the recovery in the region and the strong performance in Europe and the United States suggest that the same synergistic forces propelling the rest of the region will help pull up the Japanese economy—a case, Aghevli said, of “the tail wagging the dog.” A potential concern, however, is the risk of a sharp appreciation of the yen, whose movements, Aghevli said, are difficult to predict, since they do not always reflect fundamentals. In his opinion, however, the Bank of Japan will intervene to keep the yen from rising too much.
A secure future for emerging markets?
A year ago, Mohamed El-Erian said, emerging markets were in turmoil; investors were still reeling from the Asian and Russian financial crises; and the IMF was on the receiving end of bad press from all quarters. A year later, growth is picking up in most emerging market countries; investors are flocking back; and the IMF is winning praise for its handling both of individual country problems and of the risk to the international financial system.
Do these developments, El-Erian asked, signal the emergence of these economies as “islands of stability” in a turbulent international environment, or simply the upswing in a cyclical process that could downshift into another round of turmoil and disruptions?
For many emerging market economies, El-Erian said, 1999 was a year when three “key stars” were in alignment: better country fundamentals as several countries strengthened their domestic policies; a supportive external environment, as U.S. growth remained buoyant and picked up in Europe; and favorable market technicals (that is, not only were cross-border flows returning to the emerging markets, but the deep devaluations that had driven these flows out in the first place had also shaken out much of the over-indebtedness and over-leveraged investments built up in the mid-1990s).
Despite these favorable developments, emerging markets face a “choppy” outlook, El-Erian said, as generally supportive internal factors compete with more difficult external ones. Because the recent policy strengthening has been rooted in structural improvements and institutional gains, domestic policy fundamentals are expected to continue to improve, El-Erian said. But private investors are keeping “three issues on the radar screen”: the risk of policy complacency; the difficulties emerging markets typically face in “managing success”; and uncertainties about the sustained implementation of better policies in some systemically important countries (such as Argentina, Russia, and Turkey). Market technicals are expected to remain generally supportive, El-Erian said, as the impact of low valuation is replaced by a broadening of the investor base, and crossover funds gradually flow back into the markets.
The external environment could be more problematic, however. For one thing, the risks of a slowdown in world growth could be increasing. Also, perceived dislocations in major industrial country financial markets could lead to an increase in average investor risk aversion and a reduction in the relative attractiveness of emerging market assets.
For countries with IMF-supported programs, El-Erian said, this murky outlook accentuates the importance of sound economic policies and appropriate contingency plans that lessen the economy’s vulnerability to negative contagion from disturbances in external financial markets. The need to provide markets with timely and comprehensive information is also very important, and the IMF can play a vital role in this regard, El-Erian noted.
The IMF could also provide an important service to the market, El-Erian said, by acting as an international clearinghouse for information on how the market is positioned. Information helps to smooth out the market and prevent the abrupt reversals resulting from “betting on boxing matches staged in the dark.” The IMF could also play a useful role as an objective advisor in helping countries, rather than investors, exploit market imperfections.
Involving the private sector
Agreeing with his fellow panelists that the overall prospects for emerging markets are generally good, Mahmood Pradhan voiced similar concerns. A global economic slowdown could dampen the market’s newly restored enthusiasm for emerging market assets, even in countries, like those in Asia, with strong economic fundamentals, he cautioned. For countries in Latin America, which are currently facing a steep external financing requirement, a worsening in the global environment could have a seriously damaging impact.
Turning to recent developments in financial markets, Pradhan said that for hedge funds and leverage institutions, the price of holding positions is back to precrisis levels. There is now less of a risk of a systemic crisis, he said, but the potential remains for leverage positions to get out of hand again if market volatility begins to rise.
Both the official and the private sector have been grappling with the knotty problem of damage control and reconstruction after a financial crisis. Pradhan said that private sector involvement was essential in this effort, because the official sector lacked the resources to cover all the shortfalls, while the private creditor community could handle defaults relatively easily. What was lacking in current debt reconstruction strategies, Pradhan said, was the ability of the private sector to do its own credit risk assessment. This lack could be filled by an open exchange of information between the IMF and private creditors. The terms of IMF-supported programs for a country seeking financial assistance should be made public, including the proportion of adjustment the country needs to make, how much of the financing gap the official sector is willing to provide, and the conditions that need to be met before this financing is disbursed. The more complete such information is and the more widely disseminated, the better equipped the public sector is to make its own risk assessment and to decide how fully it wishes to participate. The price of not participating is a bigger “haircut” all around, Pradhan said, so the IMF should remain firm and resist any attempts by small groups of creditors to negotiate better terms, since this could set a dangerous precedent for future debt workouts.