Boom to bust
Emerging markets view drooping exchange rates as an existential threat. Every bout of panic selling in their currencies – like the one set off recently by Argentina’s devaluation – leads to talk of crisis and contagion. Interest rates are jacked up to “defend” the Turkish lira last month or the Indian rupee last July.
But exchange rates are hardly a matter of national honour. A slide brings both costs and benefits. Importers lose; exporters gain. Tourism gets a boost, even though the local-currency cost of imported oil zooms. Why then do emerging markets – and their investors – portray episodes of sharp depreciation as “crises” when similar movements in, say, the Japanese yen or the Australian dollar are characterized as mere “adjustments”?
The standard answer is fragility. Borrowers in emerging markets load up on foreign-currency debt in good times; and have difficulty paying up when dollars become more expensive. Similarly, banks in developing countries rely heavily on overseas credit lines because domestic savings aren’t sufficient. Equity markets depend on hot money. Currency depreciation, if it turns vicious, can make financial engines seize up.
While fragility is a valid concern, the root of phobia lies in the way policymakers mishandle booms. They allow local prices to gallop ahead of productivity growth. When this goes on for a long time, it becomes obvious that only a slump in the exchange rate will take the economy back to more reasonable price levels. But this reset – because it occurs in an environment of failing companies, struggling banks, soaring inflation and surging unemployment – has social and political consequences. Governments can fall, as in Indonesia in 1998. For emerging markets to conquer their fear of floating currencies, they must first learn to manage booms better.
One way to distinguish competent managers from inept bunglers is to look at the price level for an emerging market as a fraction of U.S. prices in 1990 and 2010. Then look at how labour productivity has changed relative to the United States over the same period. If relative prices have soared without productivity catching up, the country’s currency might have to fall to make the economy more competitive.
Take Venezuela. In the two decades from 1990, the ratio of Venezuelan to U.S. prices rose by 75 percentage points. Yet Venezuelan productivity fell by 13 percentage points compared to U.S. productivity. Thus Venezuela accepted a rising real exchange rate against the dollar without higher labour productivity justifying the gains. Little wonder that it should be fearful of a reversal.
Chile offers a stark contrast. Chile’s prices relative to U.S. prices have grown a modest 7 percentage points in two decades. And almost all of the increase has been due to workers’ productivity gains. South Korea and Taiwan have done even better. The ratio of Korean to U.S. prices has risen very little in two decades, while Taiwanese output has become less pricey compared with the United States, despite Taiwan doing better on productivity. The result is that Korea and Taiwan are unlikely to face a currency crisis.
The economies that have allowed their price levels to balloon are scared of a messy reset because the tide of easy money is receding. That tide, especially the kind triggered by quantitative easing in rich nations, has helped to inflate price levels in emerging markets. Yet policymakers have historically had a rather limited toolkit to deal with it. It’s only now that attempts by developing countries to limit hot money inflows are seen as legitimate. Measures once derided as throwing “sand in the wheels of global capitalism” are now being feted as prudent. Even so, it’s hard to repel incoming capital, and preventing it from going out is tougher. Witness the recent surge in gold smuggling into India as a response to capital controls on residents.
The best antidote to an eventual bust is to focus on productivity in good times. That means pumping resources into education, health and infrastructure and keeping a lid on wage expectations. It’s worrisome for investors that between 2010 and 2013, output per worker fell in Turkey, Brazil and Mexico. After jogging briskly on the productivity treadmill for two decades, China is also looking tired. But if it stopped to catch a breath, the economy’s price level will start looking bloated; and the current optimism about the yuan will fade. Managing a bust is never easy, but it’s harder for nations which mismanage their booms.