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Emerging-Market Investors Have Poor Memories

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(Bloomberg View) -- If you're ever looking for examples of hope triumphing over experience, look no further than the emerging-market economies.

Even as the Federal Reserve tightens U.S. monetary policy, both investors and policymakers in those economies seem to be in denial about the likely fallout, clinging to the hope that somehow the impact of this round of global liquidity tightening will be less disastrous than earlier such rounds.

Indications abound of emerging-market investors’ positive frame of mind. The interest rate spread of emerging-market corporate bonds over U.S. Treasuries is close to its record low. Despite some recent widening, emerging-market sovereign debt spreads still remain low by historic standards. Meanwhile, investors keep oversubscribing to debt issues by very weak emerging-market credits like Iraq, Kenya, Mongolia and Tajikistan.

For their part, emerging-market policymakers seem to be making few preparations for a rainy day. Instead of using the good times to reduce government debt levels, they keep taking advantage of the favorable global liquidity conditions to tap the market. The International Monetary Fund estimates that emerging-market sovereign debt levels in relation to GDP have now reached levels last seen during the 1980s emerging-market debt crisis. 

At the same time, emerging-market policymakers have done little to rein in the major borrowing spree on which their corporates have been embarked. This has been the case even though those corporates have almost trebled their debt since 2008.

Previous Fed tightening cycles have not been happy ones for the emerging-market economies. Rising interest rates in the U.S. have generally resulted in the large-scale repatriation of capital that flowed to the emerging markets when U.S. rates were low. In turn, such sudden stops in capital flows have tended to cause serious financial market strain and acute balance of payments pressure for those emerging-market economies.

Despite their experience with previous global liquidity tightening cycles, both emerging-market investors and policymakers seem to be pinning their current hopes on stronger emerging-market fundamentals. They seem to be counting on emerging markets being more resilient than they were before to conditions of reduced global liquidity.

Yet in so doing, investors and policymakers are turning a blind eye not just to high levels of emerging-market sovereign and corporate indebtedness, but to the large imbalances and political challenges in some of the largest emerging-market economies. They also seem oblivious to the out-sized role of emerging markets with very low credit ratings -- Brazil and Turkey, for instance -- in the borrowing binge. 

Among the major developments that emerging-market investors have largely seen fit to ignore:

  • Brazil’s public finances remain on an unsustainable path at a time when it faces a contentious presidential election in October.
  • In Mexico, left-leaning populist Andres Manuel Lopez Obrador is on course to win the July presidential election, potentially putting Mexico on a collision course with the United States and undermining the country’s energy sector reforms.
  • China is experiencing a credit bubble of epic proportions even as it risks drifting into a trade war with the United States.
  • Turkey could face a full-scale currency crisis as President Erdogan feverishly primes the economy ahead of forthcoming parliamentary elections.

The Fed will very likely soon need to increase interest rates at a faster pace than planned in order to prevent the U.S. economy from overheating. Consider, for instance, the still very easy U.S. financial conditions and the expansionary stance of fiscal policy at this late stage in the economic cycle.

Should the Fed indeed tighten more quickly, we won't have to wait long to see if emerging markets fare better with global liquidity tightening than they did before. Judging by the emerging markets’ presently high debt levels and their deteriorating economic and political fundamentals, I wouldn't want to bet the house on the notion that this time will be different.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.

©2018 Bloomberg L.P.

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