Financial markets are prone to public hand-wringing about impending dangers, not least because this creates more volatility, with its profit-making opportunities. As well as worrying about China, world commodity prices, and US monetary policy tightening, markets are concerned about disruptive capital outflows from emerging markets.
It is no comfort that this volatility is caused by the market itself: it results from each player's attempt to shift investment funds ahead of the rest. When some investors decide it's time to leave, this quickly turns into a lemming-like rush. Bonuses depend on being first in the exodus.
With the increased integration of global capital markets, capital flows readily in response to interest differentials between countries, and in large volume. The flows also reverse, much more suddenly, in response to changes in sentiment. One moment, market participants are 'risk on': prepared to take a chance on investing in countries about which relatively little is known. Then, always with one eye on their rivals, investors can switch overnight to 'risk-off': suddenly fully aware of their ignorance about the fundamentals of the investment and concerned only to get out ahead of the pack.
The sequence since the financial crisis of 2008 goes like this: at first, foreign investors fled emerging markets as part of the generalised panic. Then, when they saw most emerging economies had come through the crisis rather well and, encouraged by the large interest differential created by the near-zero rates in the crisis economies, investors shifted more of their funds into emerging markets – the 'search for yield'. Of course not all investors did this. But global investors' portfolios are huge compared with the size of financial markets in emerging economies, so the flows pushed up exchange rates in the recipient economies (which of course reduced the international competitiveness of these economies), thus encouraging current accounts to move into deficit.
Compared with the pre-crisis period, the composition of these flows has changed. Global banks, chastened by their 2008 experience, have not participated much. Bond markets have taken their place. Emerging-economy companies have shifted towards foreign-exchange-denominated bond issuance, making borrowers vulnerable when exchange rates shift.
Such inflows sow the seeds of a subsequent damaging reversal. Exchange rates in emerging countries start to look overvalued, and current account deficits cause concerns. Then some trigger, often arbitrary, sets off a rush for the exits.
In emerging economies with small financial markets and a relatively short history of exchange rate flexibility, these volatile flows can cause substantial damage (as was demonstrated in the 'taper tantrum' in May 2013).
So where are we at now? If markets worked in accordance with the text-books, investors would have already incorporated all the likely risks (ie. China slowing; Fed interest rate changes and so on) into today's prices, and investors with above-average concerns about such eventualities would already have taken their money out. But markets don't work like that. Correlated expectations (meaning everyone changes their minds at the same time) lead to volatile flows that local authorities can't do much about because the main drivers are external.
Over time, policy responses are developing. In the past 10 years, the consensus (as represented, say, in IMF documents) has shifted from believing that free markets would sort out an optimal solution to acknowledging a problem exists. There is, however, still no convincing policy solution. The current panacea is 'macro-prudential controls', which are various kinds of financial market intervention (loan/valuation ratios; loan/deposit ratios; restrictions on bank balance sheets; and additional bank capital). This takes us back to the pre-deregulation world when authorities tried to steer bank behaviour, but managed only to shift the financial action away from the regulated banking sector and toward non-bank institutions (this process used to be called 'disintermediation', now it's referred to as 'the rise of the shadow banking sector').
The recent IMF Global Financial Stability report addresses all this, without any real hope that financial markets will remain sanguine during the Fed's 'will it, won't it', tightening phase. The IMF's concern focuses on lack of market liquidity: investor portfolios are distorted by the extreme policy settings of the post-crisis period, so rapid changes in balance-sheet holdings will cause big shifts in bond prices and exchange rates.
The IMF's prescription doesn't get much beyond urging vulnerable countries to run impeccable domestic policies. Most emerging economies in Asia, imperfect though their macro policies may be, are in reasonable shape to ride this out. But there are exceptions elsewhere: Brazil is now mired once again in the chaotic under-performance that has characterised this economy. It seems destined to remain the 'country of the future'.
Hanging like a dark cloud over market sentiment, China's mild slowing is being overplayed. Journalists can — and no doubt will — continue to give air time to those predicting a repeat of the 1997-98 Asian crisis, but there is an excellent chance that these economies (including China) will continue doing quite well, particularly when judged against the disappointing performance of most of the mature economies.
Image courtesy of Asian Development Bank