Is a US recession the best thing that can happen to emerging economies?

The writer is in charge of emerging market economics at Citi

“US recession now!” it just doesn’t seem like the most obvious battle cry for emerging economies. However, the fact is that a US recession may be what it takes to make room for a reliable drop in US real interest rates and a reliable weakening of the dollar.

And that easing of US monetary conditions would certainly do emerging economies good now. The recent tightening of these conditions has had rather dire consequences for them. It has eroded their access to international capital markets; increased risk of debt default, especially for low-income countries; and destabilized their currencies, pushing price stability even further from the grasp of even the most skilled central bank.

The idea that capital flows will return to emerging markets in the wake of the US recession has a history that backs this up. Two episodes in particular are worth considering: the early 1990s and the aftermath of the global financial crisis in 2008.

The United States has experienced recessions since 1990 and 2007 that lasted eight months and 18 months, respectively. Both of these episodes allowed for a significant easing of US monetary conditions, which helped trigger capital inflows into emerging economies after a period of risk aversion not unlike the one we have recently experienced.

In 1992, for example, international capital markets provided net loans to emerging economies in the amount of around 1% of GDP after nearly 10 years of stealing money from them. By 2010, that flow had risen to 2% of GDP after two sterile years of the Lehman crisis and its aftermath.

It must be said that both of these episodes ended badly: the increase in capital flows in the early 1990s stopped abruptly with the tequila crisis in Mexico in late 1994. And the boom in post-capital inflows. The financial crisis ended with a series of setbacks: a sharp sell-off in asset prices in late 2011 and the “taper tantrum” that began in spring 2013 when the Federal Reserve triggered market turmoil by tightening monetary policy.

It is also true that these two “boom episodes” in capital flows to developing countries were not entirely the result of easing US financial conditions, as there were other factors at play.

Such easing is best understood as a “push” factor for capital flows: investors want to seek higher yields from developing countries when US rates are low and when the value of the dollar is falling.

But the “pull” factors are also relevant. You can think of these as the growth potential of emerging economies, the effort their policy makers make to encourage long-term investment capital inflows, and the general confidence market participants have that “things are going well” for developing countries.

Thinking back to those two historical episodes mentioned above, it is worth underlining that on both occasions the “attraction” factors were quite strong.

In the early 1990s, emerging markets benefited from investor enthusiasm for the benefits of globalization and from the effort that countries – Mexico, Turkey, Thailand and the like – were making to reduce trade barriers, integrate into global economy, cut budget deficits and reduce inflation.

In addition, since the early 1990s, a number of countries had benefited from debt relief under the Brady Initiative. So emerging market balance sheets were perceived as cleaner than they were in the crisis period of the 1980s.

Likewise, the post-financial crisis context also saw a substantial “pull” factor for EMs. Emerging economies were relatively unscathed by the crisis, while growth expectations were bolstered by China’s late 2008 decision to launch a broad stimulus program, which revived global commodity prices and growth in world trade.

It is difficult to pinpoint the strong pull factors of emerging markets today. Global trade growth is weak, which disproportionately harms developing countries. Protectionism is on the rise as geopolitical tensions threaten globalization. And there is little evidence of domestic economic reforms that are conducive to growth, with exceptions like Indonesia or Vietnam.

Hence it is likely that “push” factors will be important in determining capital flows to EMs. The trick will be to ensure that any boom in such post-US recession flows does not turn into failure, as in the past.

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