Residential apartment buildings stand on the city skyline in Istanbul, Turkey. (Photographer: Kostas Tsironis/Bloomberg)  

Why Some Emerging Markets Are Suddenly Melting Down: QuickTake

(Bloomberg) -- Investors had been enamored with emerging markets for more than two years. These days, they’re not so besotted. For several weeks, money has poured out of developing nations and into the U.S., causing the dollar to rise in value and the currencies of emerging markets to hit new lows. Turkey has been at the center of the rout, but many other countries, including Argentina, Hungary and Indonesia, have been hit as investors dump riskier stocks and bonds for the safety of U.S. assets. For some economists, it raises the specter of the late 1990s-era Asian economic crisis. What’s going on?

1. Why are emerging markets suffering?

The easy answer is that money is fickle and opportunistic -- it goes where it can get the highest return, flowing out of countries as fast as it flows in. This latest upheaval started when the U.S., Japan and Europe kept interest rates close to, or below, zero to help their stagnant economies recover from the 2008 financial crisis. That made returns on stocks and bonds unattractive, and drove investors to developing nations, where the risks were higher but the payoffs more inviting. Emerging markets, as a result, have enjoyed a rally in stocks, bonds and currencies. But the reverse is now happening as investors react to several signals from the U.S. -- faster growth, rising interest rates and a stronger dollar. All three indicate potentially higher returns on U.S. investments and thus act as a magnet for money. They also undermine the attraction of riskier emerging markets. The turmoil in Turkey has especially rattled investors.

2. How scary can this get?

Some say this is just a market hiccup as speculative investors betting on a weaker dollar were caught off guard by the U.S. currency’s new strength. Others say the developing world is in worse shape than many investors think. Harvard professor Carmen Reinhart, for example, has said mounting debt loads, trade battles, rising interest rates and stalled growth have made emerging markets more vulnerable than on the eve of the 2008 financial crisis. Paul Krugman, the Nobel Prize-winning economist, has said the current episode somewhat resembles the Asian financial crisis of the late 1990s, when the MSCI Emerging Markets Index for developing-nation stocks slid as much as 59 percent.

3. What caused the Asia crisis?

It started when a real-estate bubble burst in Thailand, which undermined confidence in the economy, causing foreign investors to sell the currency and withdraw from the stock market. The crisis spread to the banks, and then across much of East Asia. Many of the afflicted economies had strong growth records that masked weaknesses like nonperforming bank loans, heavy foreign borrowing and rising trade deficits. Because their currencies were pegged to the dollar, South Korea and other nations were forced to spend billions trying to fend off speculators who were selling their currencies. They soon ran out of dollars and had to give up the peg and devalue their currencies. The contagion spread when foreign investors pulled back from other countries in the region seen as having similar problems. Several ended up seeking bailouts from the International Monetary Fund.

4. So is this another Asian-like crisis?

No, at least not yet. One reason: Investors are selectively punishing markets where policy makers haven’t done enough to stem deteriorating trade balances and ballooning inflation. These include Turkey and Argentina, which have the worst combination of weak governance and high dollar debt among 18 major emerging-market economies. Brazil and Indonesia aren’t far behind.

5. Who else looks vulnerable?

Economies dependent on dollars and other foreign currencies to finance their trade deficits -- the Philippines, India and Indonesia stand out -- have the worst-performing currencies in Asia this year. Those with the highest rates of foreign ownership of government bonds could be the most vulnerable to capital outflows, including South Africa, Indonesia and Russia.

6. Why is Turkey in so much trouble?

It’s been one of the hardest-hit emerging-market currencies, shedding more than 17 percent of its value against the dollar this year. Turkey has a large budget shortfall and one of the biggest trade deficits in the G-20 group of nations. And though Turkey’s inflation rate is more than 10 percent, its central bank was prevented from raising interest rates by President Recep Tayyip Erdogan, who is seeking re-election in June and says he prefers low interest rates, based on his own ideas about monetary policy. He has also said he plans to take more control over monetary policy if he wins. Last week, the central bank took emergency steps to arrest the slide with an interest-rate hike to prop up the lira, and followed this week with a simplification of its interest-rate regime. All of this has made Turkey seem more risky to investors.

7. Why did so many countries borrow in dollars?

Encouraged by near-zero interest rates after the global financial crisis, developing nations loaded up on what was then cheap debt. Selling bonds denominated in dollars rather than the local currency also attracted investors who favored the more stable greenback. Turkey’s corporate sector, for example, has foreign currency debt in dollars, equivalent to 40 percent of gross domestic output. Global investors, though, sometimes ignored danger signs, such as rising trade deficits and government spending sprees. They also brushed aside, until now, the fact that a stronger dollar would make it harder for emerging markets to repay their debt. That’s because once they borrowed in dollars, they needed to buy dollars to repay the debt. As the dollar rises in value against the local currency, it costs more to obtain those dollars.

The Reference Shelf

  • A QuickTake explainer on Turkey’s vulnerability.
  • How some of the key emerging-market indicators have evolved since 2008.
  • Emerging-market companies and governments straining to deal with the rising cost of borrowing in dollars face increasing pressure as a record slew of bonds come due.
  • Investors are punishing markets where policy makers haven’t done enough to stem deteriorating current-account balances, ballooning inflation and a run on their currencies.
  • The Institute of International Finance lowered its forecasts for portfolio flows to emerging markets after investor appetite for debt tapered off significantly.
  • Should emerging markets worry about U.S. monetary policy announcements?

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