Emerging Markets

Inspired by Bloomberg asking whether Australia will suffer in the same way as emerging markets - Australia Looks Like an Emerging Market - I had a fun discussion over the weekend in a comments section elsewhere. My immediate reaction is that no, Australia is not an emerging market - it is a highly developed commodity exporter with a high currency correlation to an index of raw commodities - but further, that I think people are making a mistake in equating a currency devaluation with an automatic crisis. Some of the emerging markets might not actually be having emerging market crises, depending on their monetary system/borrowing arrangements. I'll mainly use Australia in this example, because I'm less familiar with emerging markets - particularly the smaller ones - however my rudimentary knowledge of emerging markets crises tells me that Australia is in no danger.

First, it makes sense to acknowledge that a floating exchange rate is supposed to act as an automatic stabiliser – it is not in itself a cause of crisis, and there is no reason to panic if the market decides yours should move lower. In previous cases, the crisis occurred because the country was either trying to run an inflexible monetary policy or it did not control the currency its debt was issued in. The actual loss of value of the currency was not the main crisis – it was inevitable - but they either fought it and failed, or didn't realize it would hurt poorly constructed balance sheets leading to default. In essence, emerging market crises occur when exchange rate depreciation exposes an inherent flaw in that country's policy, and forces a default or a collapse of monetary policy.

In the case of a failed currency peg, the operational structure of the central bank was fragile, in that currency devaluation would force the central bank to divest itself of its foreign reserve holdings. If that attempted currency depreciation was prolonged, the central bank would eventually run out of reserves with which to defend itself, and would be forced to devalue in an uncontrolled manner, causing volatility and crisis in financial markets. This was at the heart of the Asian financial crisis in 1997, and a similar consequence befell the U.K when it was in the E.R.M:

The Thai Baht collapsed in a disorderly fashion.

Alternatively, some emerging markets borrow in a currency other than their own, as they lack the credibility to attract foreign capital in local currency denominated securities - here we might think of South America including, more recently, Argentina. This presents a huge problem, should the exchange rate move against their favour. As Eichengreen & Hausmann (2003) explain:

"... Consequently, emerging market countries that effectively make use of international debt markets by accumulating a net foreign debt will necessarily assume a balance sheet mismatch, since their external obligations will be disproportionately denominated in dollars (or yen, euros, pounds and Swiss francs), while the revenues on which they rely to service those debts are not.

 Exchange rate changes will then have significant wealth effects. In particular, the currency depreciation that is the standard treatment for an economy with a deteriorating balance of payments may so diminish the country’s net worth that the adjustment of the currency is destabilizing rather than stabilizing: the dollar value of its GDP declines, while the dollar value of its debt service does not. The realization that the normal adjustment mechanism has been disabled will alarm investors, heightening the volatility of capital flows and introducing the possibility of sudden stops, current account reversals, and self-fulfilling currency and debt-sustainability crises."

In both cases, the problem isn't that emerging markets aren't to be trusted, but rather that this lack of trust inherently leads to them adopting sub-optimal borrowing patterns or central bank policy - this is why the exchange rate creates a destabilizing effect, rather than the stabilizing experience felt in developed markets. This EM problem is then exacerbated by developed market liquidity being withdrawn rapidly under monetary tightening that originates in countries such as the US - a central theme of Michael Pettis' book, The Volatility Machine, and perhaps what we are seeing currently.

Back to Australia:

Neither of these frailties is found in the makeup of Australian borrowing. Government liabilities are denominated in Australian dollars, as the country has credibility and low public debt - leading to strong demand for bond issuance. Similarly, private sector borrowings are largely either AUD denominated, or hedged, such that any fall in the currency will be largely offset by gains on hedging instruments or is not of consequence to AUD issued debt. In both cases, the RBA can control interest rates, and there is no strong possibility of external funding spiraling out of control of the domestic authorities.

But, more than this, Australia has already experienced a rout from its currency in recent history, and from this we can draw conclusions. When the GFC hit, the carry trade in the AUD unwound as the price of commodities fell drastically. The dollar fell roughly 40% over a few months. Of course, there was no currency crisis, or trouble funding debt issuance, because the debt was largely AUD denominated - in fact, yields fell with the currency. Over the next few years, the AUD should grind lower as commodity prices come under pressure. Far from creating some sort of emerging markets crisis, this will restore some competitiveness to Australian labour and manufacturing that has been lost under the commodities boom of the last decade. 

Could this cause inflation (as I saw suggested over the weekend)? Perhaps, but given that a collapse in the value of the AUD would typically occur in response to collapsing commodity demand (i.e China crisis), which is deflationary and acting on top of already very low global inflation, there is little reason for panicking about rising inflation or the RBA needing to raise rates to defend the currency.

The unwinding carry trade saw the AUD lose 40%

Australia, as a sovereign currency issuer, with its debts denominated in that currency, is unlikely to fall in to the same trap as emerging markets have in the past. It is also unlikely to experience anything similar to the Greek experience, because Greece is a currency user, not a monopoly issuer, and the Euro effectively mimics some of the effects of having borrowed in a foreign currency with a pegged exchange rate - Greece can not create Euros whenever it desires to ensure solvency, nor can it have a flexible exchange rate within the currency union. In this respect, the Euro area is far closer to emerging markets than Australia, and Euro countries are more fragile operationally than Australia, despite its correlation with some emerging market currencies.