Relying on the kindness of strangers is risky business

One crisis after another. As hopes have risen for a normalisation of the world economy following the Great Financial Crisis, a new storm is brewing, this time in emerging markets. The narrative is straightforward: all that money created by mostly western central banks, desperate to mitigate the worst effects of the crash, found its way into fast growing, usually smaller, markets. Now that the US and UK central banks, at least, no longer seem to be quite so keen to pump money into their economies, global capital flows are reversing. Investors are selling the currencies and stock markets of countries such as Turkey, South Africa, India and others.

The emerging markets crisis of the late 1990s is still reasonably fresh in the memory: it started in Thailand and ended in Brazil. It came out of nowhere and ended just as many people expected it to get worse. I recall one prediction, from the world's leading investment bank, that if the Brazilians devalued their currency the crisis would enter a new and much more damaging phase. When the Brazilian Real was duly allowed to sink, the crisis mysteriously evaporated. As always, we need to treat predictions with great care.

Some central banks appear to be handling things badly: interest rate rises designed to protect the domestic currency end up only making things worse if they unnecessarily depress the economy. We have seen this happen time and again over many years and it is depressing to see the apparent lack of learning.

If this really is all about hot money flowing out of some markets in response to the Federal Reserve’s recent decision to scale back on its liquidity injections, the authorities in the countries concerned might be better advised to let things run their course, to let exchange rates take the burden of adjustment. The last emerging crisis was in part exacerbated by the defence of fixed currency pegs that no longer exist. Flexible exchange rates should be allowed to do what their name suggests. Higher import prices are a genuine concern but their consequences should not be overstated.

Proper investors can testify to some of the idiocy surrounding flows to emerging markets. Global equity managers for years now have been faced with one demand from clients: get me more emerging market exposure. Note the lack of any qualifying demand about exposure “at a sensible price”. Now, the demands are to sell emerging market stocks, also without regard to underlying valuations. The herd stampedes one way and then the other.

Destabilising global capital flows are an obvious worry. Calls to “throw sand in the wheels” of markets will inevitably grow louder. It is hard not to be sympathetic: Chinese resistance to the opening up of their capital markets is beginning to look prescient.

Apart from outright capital controls, the only defence that can be put up to hedge funds (in particular) is not to borrow from them in the first place. The public sector has a big role to play here and is another reason to admonish governments who borrow too much, particularly from overseas. If you don’t like speculators, don’t take their money. Of course, it is much harder to control private sector flows: our own crisis was essentially caused by our domestic banking system borrowing from foreigners.

And we were not alone, hence the response of regulators in Europe, in particular, to stop this from happening again. It's called "macro-prudential" regulation. Whether it works remains to be seen, but there remains an underlying suspicion that not nearly enough has been done. If bankers believe they have
managed to minimise the regulatory backlash, I suspect they will have to think again. The chatter from the relevant authorities is that with each step towards restored banking health, the regulatory noose will correspondingly tighten.

If the emerging markets do deliver a major shock that spreads to Europe, then Mario Draghi’s famous promise to “do whatever it takes” to save the euro will, finally, be tested in combat. If Europe is sent back into recession, it is probable that we will see a full resumption of the euro crisis.

It is far too early to be that gloomy. But we need to be on our guard. There isn’t all that much we can do to protect ourselves from an external shock other than to continue to minimise our reliance, in Morgan Kelly’s memorable words, on the kindness of strangers.

Foreigners are buying our bonds again but their largesse, as other counties are discovering, can evaporate in a heartbeat.