What Caused Those Dramatic Emerging Market Currency Dives? - Liliana Rojas-Suarez and Arvind Subramanian

October 07, 2013

Shutdowns come and shutdowns go. The rest of the world watches Washington’s political antics and scratches its collective head. This Wonkcast was recorded before the current shutdown, when capital was rushing out of emerging markets and back to the US in anticipation of rising interest rates. While the slide in emerging market currencies has paused as investors reassess risks in the US, the underlying dynamic we discuss is still very much at play.

Emerging market currencies have seen a lot of action over the last few months. India’s rupee has fallen 20% against the dollar, the Indonesian rupiah and the Brazilian real are floundering after falling 15%, and Turkey’s lire has slipped 10%. I invited CGD senior fellows Liliana Rojas-Suarez and Arvind Subramanian to explain what’s driving the fluctuations. Since these economies have mosty been performing pretty well—consistently growing faster than the rich countries—to the untrained eye, the currency slides seem dramatic and unexpected.

“This is not totally unexpected,” Liliana says. “The global financial crisis brought a huge expansion of global liquidity that everyone knew would eventually have to be reversed. That's what is happening now. There are signs of the US starting to recover, and there are also signs that the expansionist monetary policy in the US is going to stop. This means that investors around the world will have to make a reassessment in their portfolio.”

In other words, investors have been shifting some of their funds from the emerging markets back to the US, in anticipation of rising interest rates.

“The question,” Liliana says, “is not really whether the emerging market currencies depreciate, it's how fast. It's taking place so suddenly that some countries are having difficulties to make good on their foreign obligations.”

Arvind is quick to point out that not every emerging market country is experiencing currency shocks.

“China is a great example. Its currency has gone up, and so have several Latin American nations such as Mexico. It's the interaction between what countries do domestically and these external triggers that determines how well you fare and how you can adjust against these shocks,” he says.

“The five countries that have been hardest hit are India, Indonesia, Brazil, South Africa, and Turkey, which have great external financing problems—their current account deficits have been very high. They need money to finance the deficits, and that's where foreign investors come in. When investors leave the economy, they create further problems for the emerging economy.”

Our conversation turns to the bigger question these currency fluctuations pose—the pros and cons of full integration with global financial markets.

“If you look at the outstanding development success over the last 25 years,” Arvind says, “there's no contest that it's China. China has chosen not to integrate itself into global financial markets. It's kept its currency very cheap and competitive relative to where it should be, it’s become an export powerhouse but the economy doesn’t go up and down from the ebb and flow from global finance. The question is: why isn't this something other countries should emulate? Why shouldn't other countries emulate China?”

Liliana says its all about sequencing: “I do not mean that all economies must open their capital accounts at the same time without anything else in mind. Latin America has gone through a process of opening with many crises, so we should remember that. What I argue is that countries should go through the right sequencing of liberalization.”

First comes trade liberalization, Liliana says.

“Then you make sure your domestic financial system is fine. Then you start liberalizing your domestic financial system. Once you've done that, you start opening your international capital account for long-term foreign direct investment. Finally you open for short-term capital inflows. I don’t know whether China is in a position to open the capital account because there is no transparency there and, therefore, I can’t know what the state of the domestic financial system is. If it is weak, which I believe it is because non-performing loans might be accumulating in light of the economy’s deceleration, then I don't think China is ready to financially open. However, do you really want to emulate a country that is not transparent and lacks strong institutions? Shouldn't we address why China’s model might not be sustainable?”

Arvind’s response: “People always believe that integration has benefits and costs, but the aim is to maximize benefits and minimize costs. Washingtonians always come down in favor of ‘let's keep opening.’ In India the trend for greater capital market opening has to do with the domestic political strength of those who rely on foreign finance. We've been borrowing dollars abroad to keep lending firms dollars, which results in mismatches: liabilities in rupees and assets in dollars. It happens because big companies want to borrow dollars despite the cost on the rest of the economy.”

We end the Wonkcast with Arvind and Liliana agreeing to disagree.

My thanks to Aaron King for an initial draft of this blog post, and to Kristina Wilson for recording the Wonkcast.


CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.