Reversal of Fortune

– From excess liquidity to financial drought in the emerging world

After years of rapid economic expansion emerging nations are facing renewed economic hardship as weak balance of payments positions come under the microscope

When rebalancing is not good news

Before the global financial crisis, it was typically argued that the world economy needed to “rebalance” to guarantee lasting economic health. Developed economies had excessive current account deficits while emerging economies had excessive surpluses. If only these imbalances could be reduced, the world economy would be a much happier place.

It turns out that this was too optimistic a view: imbalances have narrowed but it has been a “recessionary” rebalancing, associated with dwindling demand for emerging market exports, undesirable monetary policy contagion and, in some cases, a structural worsening of competitiveness. For a while, the promise of cheap dollars – courtesy of the Federal Reserve’s printing press – masked an underlying deterioration in economic performance in the emerging world: too much hot money and too little productive investment. The global hunt for yield encouraged huge capital inflows into emerging nations even as their economies began to slow and their labour costs rose.

For anyone who’s spent time examining the Eurozone crisis, this story might sound eerily familiar. Cheap euros from northern Europe poured into southern Europe triggering domestic demand booms even as structural economic performance worsened. The resulting current account deficits could be funded for a while but, with an increase in risk aversion following the onset of the global financial crisis, the deficits ultimately proved unsustainable.

The long-term emerging market story remains positive, supported by a series of encouraging supply side factors. In the short term, however, current account deficits will remain in the spotlight. With little improvement so far, the risks of currency weakness, higher interest rates and more in the way of disappointing growth remain uncomfortably high.