How the emerging market sell-off gets much, much worse

Tense times in Turkey.
Tense times in Turkey.
Image: AP Photo/Emrah Gurel
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We’ve already said that to understand the dangers of the current sell-off in emerging markets, you need keep an eye on the corporate bond market. Companies in emerging markets haved binged on borrowing in recent years, as super-low interest rates in large developed economies drove investors abroad in search of investments that offered a higher payoff.

And then currencies in key emerging markets tanked.

Now, in theory, this is a good thing: Conventional economic wisdom holds that when countries allow their currencies to rise and fall—a flexible exchange rate—the fluctuation actually helps cushion the economy from so-called “external shocks.” For example, when a currency falls in value against major trading partners, a country’s exports become cheaper for foreign buyers, giving the country’s export sector a leg up on the competition.

But there are downsides to flexible exchange rates too. For one thing, a currency depreciation makes debt denominated in a foreign currency tougher to repay. (If you need to pay your debt in dollars and dollars are more expensive, your debt just grew, too.) In order to repay it, borrowers have to cut spending on things like employees and new equipment. On a big enough scale, that undermines the health of the economy.

There’s one other thing, too. The woes of the corporate sector could spill over into the banking system, which—as the Great Recession demonstrated—can be disastrous for growth. An interesting paper out today from the Bank for International Settlements, the Basel, Switzerland based “central bank of central banks,” lays out three possible ways the current emerging-market selloff could go from a nasty slump in the market to a problem for the banking systems in these countries:

1. Something rotten emerges in the banks

Explanation: Because emerging-market companies have been able to borrow so cheaply from foreign lenders, domestic banks had to find other customers. In other words, they had to lower their lending standards. A sharp run up in interest rates—which happens when central banks try to fight the currency slump by raising interest rates—could expose just how weak some of those borrowers were.

2. The corporations start to pull their deposits

Explanation: As it gets more expensive for non-financial companies to borrow, they want to use their cash more. That means they take it out of the banks, where they’ve had it on deposit. That, in turn, makes it more expensive for banks to borrow, driving down profitability, and possibly making it tougher for them to fund themselves.

3. Banks aren’t as well-hedged as they think

Explanation: “Even if the local banks hedge their forex exposures with banks overseas, they still face the risk that local corporations will not be able to meet their side of the contract.” Think of this as the AIG problem. Prior to the financial crisis, Wall Street’s banks all claimed their exposures to subprime assets were well-hedged—but many of them were hedged by derivatives contracts with the insurance giant AIG. When AIG itself reached the brink of failure, the insurance policies Wall Street bought were virtually worthless. No one knows if there’s a similar problem lurking in the emerging markets.

While these scenarios may seem like an exercise in disaster planning, it’s worth thinking about. So-called “twins”—a combined currency and banking crises—have been found to be most common among financially open emerging-market economies.