Overheating in Emerging Markets: The Next Crisis?

Originally published by the Carnegie Endowment for International Peace
Participants: Anoop Singh, Frederick Jaspersen, Uri Dadush, Yukon Huang

With signs of overheating in the developing world, fears of a repeat of the 1990s Asian financial crisis or the 1980s Latin American debt crisis are surfacing. To assess the danger and outline policies that emerging markets and advanced countries should pursue to avoid such an outcome, Carnegie hosted a discussion with Anoop Singh, director of the International Monetary Fund’s Asia and Pacific department, Frederick Jaspersen, director of the Institute of International Finance’s Latin America department, and Carnegie’s Uri Dadush. Carnegie’s Yukon Huang moderated.

Conditions for Overheating Are in Place

All three speakers emphasized that the conditions for overheating—rapid growth and confidence in developing economies paired with historically low interest rates in advanced ones—are clearly in place:

• On average, emerging G20 economies are growing by nearly 4 percentage points more than advanced economies. Singh noted this is the first time a recovery has been led by emerging markets.
• Policy interest rates are at unprecedentedly low levels in all major advanced economies.
• Confidence in emerging markets is high and still rising. Emerging market bond spreads relative to U.S. Treasuries have fallen to near-historic lows while emerging market credit ratings are at record highs.

Nonetheless, Dadush argued that large emerging markets appear more robust today than in periods before previous crises. Compared to Asian crisis countries, today’s major emerging economies have much lower levels of external debt (debt owed to foreigners), higher levels of foreign exchange reserves, and more flexible exchange rates. Those countries with pegged exchange rates, such as China and Saudi Arabia, have ample reserves and large current account surpluses.

Where Are the Overheating Pressures?

Jaspersen, Singh, and Dadush outlined the major components of potential overheating. Policy makers must carefully monitor all three components, since problems in one of them could add to those in the other two:

• Domestic imbalances: Indicated by above-trend growth and inflation.
• Financial exuberance: Indicated, for example, by rapidly rising stock prices and price-to-earnings (P/E) ratios.
• External imbalances: Indicated by sharp real effective exchange rate (REER) appreciation and deteriorating current account balances.

Based on these indicators, participants agreed the risk of overheating is growing, particularly in Asia and Latin America.

Asia

Singh noted several areas of concern in Asia, the world’s most rapidly growing region:

• The output gap (the difference between potential output and actual output) in many Asian countries has closed or is expected to do so soon.
• Inflation is rising, led by food prices. Property price growth has slowed, but remains high.
• Credit is also growing rapidly, though it has moderated somewhat recently.
• Capital inflows, particularly volatile portfolio flows, are returning rapidly.

Despite these concerns, Singh noted that monetary and fiscal policy in Asia has not been tightened to prevent potential overheating and is still supportive of growth. However, he also highlighted reasons for optimism:

• Stock markets have leveled in recent months, and P/E ratios are largely in line with historical norms.
• REER appreciation in Asia has been more moderate than in Latin America, reflecting Asia’s increase in reserve accumulation.

Participants also noted overheating pressures in China, now the world’s second largest economy.

• Singh said that, after policy makers took steps to cool China’s housing bubble, housing prices have moderated somewhat. Investment in housing, however, remains high.
• Huang commented that housing prices are partly driven by capital controls on financial outflows: Chinese residents have few investment options and are unable to take money out of China.

Huang added that general inflationary pressures in China are not all bad. Wages—which are very low relative to productivity by international standards—need to rise. Inflation in the coastal regions helps rebalance China domestically, by shifting resources to the poorer regions inland, and externally, by increasing the REER.

Latin America

The recovery in Latin America has been rapid by historical standards. Fiscal and quasi-fiscal stimulus helped drive growth, which exceeded 6 percent in 2010. However, Jaspersen highlighted two major issues—rising inflation and currency appreciation—that worry policy makers.

• In Brazil, Columbia, Peru, and Mexico, inflation, though not out of control, is above the optimal rate.
• In Argentina and Venezuela, which have pursued more populist policies, inflation is estimated to be above 20 percent and rising.
• Capital flows, led by direct equity investment, have nearly returned to their 2007 levels in Latin America, putting substantial pressure on exchange rates. REERs, especially in Brazil, have appreciated considerably, straining Latin America’s global competitiveness.

Jaspersen noted that Latin American policy makers have addressed these challenges differently. Brazilian leaders have focused more on containing exchange rate appreciation than on inflation,

choosing to introduce capital controls and add to reserves rather than rapidly tighten monetary policy. Other countries, such as Chile, have concentrated on reducing the fiscal deficit, controlling inflation, and following a more flexible exchange rate policy.

Averting a Future Crisis

While signs of overheating are in their early stages, leaders should normalize policy in emerging markets soon, participants agreed. Dadush emphasized that the dangers will only increase as interest rates in advanced countries are likely to remain low for an extended period, and the growth cycle in developing countries is just returning after a massive recession. The current imbalances are not unmanageable but, left unaddressed, will require far more drastic policy changes in the future.

• Panelists encouraged policy makers to rely less on monetary tightening, which would encourage capital inflows, and more on fiscal consolidation to slow growth and inflation.
• Countries should relax controls on capital outflows to relieve exchange rate pressure. Capital controls on inflows can help, but participants agreed they should not be viewed as a long-term solution.

As the recovery picks up in advanced countries, leaders should gradually tighten policy rates and accelerate fiscal consolidation. Dadush said policy makers must not rely so heavily on monetary policy. Using it to propel the recovery could accelerate inflation, while rapid tightening could hit emerging markets with a triple whammy: a capital flow reversal, slower global growth, and diminished risk appetites.

Food Prices

Participants expressed concern that the troubling surge in food prices is spilling over to other parts of the economy.

• Singh noted that food price inflation—which hits the poor hardest—is further increasing inequality in Asia. Policy makers must ensure that growth in developing countries does not leave behind the most vulnerable segments of the population.
• In Latin America, which is largely a commodity exporter, food prices are putting upward pressure on inflation, but also improving the terms of trade, Jaspersen explained.
• Dadush commented that correcting the rise in food prices will require structural changes in food production and demand policies. This will ensure ample supply and reduce food price volatility.