Dani Rodrik Commentary: To Keep Us All Afloat

Why Must We Save Emerging Markets from Wall Street's follies?

Globe and Mail

If the world were fair, most emerging markets would be watching the financial crisis engulfing the world's advanced economies from the sidelines – if not entirely unaffected, then not overly concerned.

For once, what has set financial markets ablaze are not their excesses, but Wall Street's. Emerging markets' external and fiscal positions have been stronger than ever, thanks to the hard lessons learned from their own crises. We might even have allowed these countries a certain measure of schadenfreude in the troubles of the United States and other rich countries, just as we might expect children to take perverse delight when their parents get into the kinds of trouble they so adamantly warn their children against.

Instead, emerging markets are suffering financial convulsions of possibly historic proportions. The fear is no longer that they will be unable to insulate themselves – it's that their economies could be dragged into much deeper crises than those at the epicentre of the subprime debacle.

Some of these countries should have known better and might have protected themselves sooner. There is little excuse for Iceland, which essentially turned itself into a highly leveraged hedge fund. Several other countries in Central and Eastern Europe, such as Hungary, Ukraine and the Baltic states, were also living dangerously, with large current-account deficits and huge debts in foreign currency. Argentina, the international financial system's enfant terrible, can always be relied on for a gimmick to spook investors – in this case, a nationalization of its private pension funds.

But financial markets have made little distinction between these countries and others, such as Mexico, Brazil, South Korea and Indonesia, that appeared to be models of financial health mere weeks ago.

Consider South Korea and Brazil. Both economies have experienced currency crises within recent memory – South Korea in 1997-1998 and Brazil in 1999 – and both later took steps to increase their financial resilience. They reduced inflation, floated their currencies, ran external surpluses or small deficits, and, most importantly, accumulated mountains of foreign reserves that now comfortably exceed their short-term external debts.

But both countries are nonetheless getting hammered in financial markets. In the past two months, their currencies have lost around a quarter of their value against the U.S. dollar. Their stock markets have declined by even more – 40 per cent in Brazil and one-third in South Korea. None of this can be explained by economic fundamentals. Both countries have experienced strong recent growth. Brazil is a commodity exporter; South Korea is not. South Korea is hugely dependent on exports to advanced countries; Brazil much less so.

These and other emerging-market countries are victims of a rational flight to safety, exacerbated by an irrational panic. The public guarantees extended to rich countries' financial sectors have exposed more clearly the critical line of demarcation between “safe” and “risky” assets, with emerging markets clearly in the latter category. Economic fundamentals have fallen by the wayside. To make matters even worse, emerging markets are deprived of the one tool more advanced countries have employed in order to stem their own financial panics: domestic fiscal resources or domestic liquidity.

Emerging markets need foreign currency and, therefore, external support.

What needs to be done is clear. The International Monetary Fund and G7 central banks must act as global lenders of last resort and provide ample liquidity, quickly and with few strings attached, to support emerging-market currencies. The scale of the lending required will likely run into hundreds of billions of U.S. dollars and exceed anything the IMF has done to date. But there is no shortage of resources. If necessary, the IMF can issue special drawing rights to generate the needed liquidity.

China, which holds nearly $2-trillion in foreign reserves, must be part of this rescue mission. The Chinese economy's dynamism is highly dependent on exports, which would suffer greatly from a collapse of emerging markets. In fact, with its need for high growth to pay for social peace, China may be the country most at risk from a severe global downturn.

Naked self-interest should also persuade the advanced countries. Collapsing emerging-market currencies, and the resulting trade pressures, will make it all the more difficult for them to prevent significant rises in unemployment. Without a backstop for emerging countries, the doomsday scenario of a protectionist vicious cycle, reminiscent of the 1930s, could no longer be ruled out.

The U.S. Federal Reserve and the IMF have both already taken positive steps. The Fed has created a swap facility for four countries (South Korea, Brazil, Mexico and Singapore) of $30-billion each. The IMF has announced a new quick-dispersing short-term facility for a limited number of countries with good policies. The questions are whether these will be enough and what happens to the countries without access to these programs.

So, when G20 countries meet in Washington this weekend for their crisis summit, this is the agenda item that should dominate their discussion. There will be plenty of time to debate a new Bretton Woods and the construction of a global regulatory apparatus. The priority for now is to save the emerging markets from the consequences of Wall Street's financial follies.

Dani Rodrik is professor of political economy at Harvard Kennedy School. The views expressed in this article are his own.