Capital outflows and a sharp depreciation of several emerging countries currencies have recently grabbed the attention. This rather sudden change in market sentiment contrasts with the common wisdom that had dominated after 2009 when most emerging countries proved that they were able to overcome both the financial crisis in the western world and the ensuing economic slump.

This outcome was achieved thanks to several factors which combined their pro-growth effects : the emerging countries financial intermediaries had only limited exposure to the western toxic assets; public policies implemented in the West to prevent a systemic crisis and support demand helped mitigating the recession and facilitated the return to normal of the international trade; several emerging countries – including China - adopted pro-active fiscal and monetary policies to foster domestic demand as a substitute to export. The latter limited the consequences on commodity prices of the western world’s crisis. This, in turn, was favorable to commodity exporters such as Brazil, Russia or South Africa. Whereas, in the West, unconventional monetary policies led to very low interest rates not only in the short term but on longer maturities, the perception of a self sustained but cross-dependant path to growth in the emerging countries, which already existed before the crisis, encouraged investors to put their money in countries where interest rates were much higher than in the western countries and whose currencies were appreciating. 

This helped to initiate a foreign investment led business cycle which the peripheral countries in Europe know well: more foreign investment leads to higher growth which, in turn, leads to more foreign capital flows. This cycle can turn into a curse when money from overseas is not spent in a way that is likely to generate the future additional foreign receipts that will be necessary to pay the interests or the dividends and to pay back the debt: Spain or Greece offer good examples of this curse.

During the past few months, foreign investors in emerging countries have revised their judgment. The growth perspective in many of these countries has been revised downward. In several countries, growth in the last few years was mostly the result of increased household consumption and the stock of capital remains too low to foster long term growth. The resulting level of the current account deficit in the countries which are not large commodities exporters has reached a worrying level except in China. In this country, the situation is different. Growth has been fueled by an excess of investment rather than an excess of consumption. This was made possible through the very rapid development of credit, especially loans to companies and trust funds set up by local authorities, with land being used as collateral.

Earlier this year, the FED announced that it was contemplating to reduce the pace of its net purchases of government issued or government sponsored securities. Quite logically, this led to an increase in mid to long term interest rates in the US. This announcement was preceded by better but not exhilarating news on the pace of growth in the US and followed, more recently, by the publication of some more positive indicators in the Eurozone.

With most countries having a flexible exchange rate, investors are willing to be the first to flee away for fear of losing on both sides: decreasing prices of the assets in local currencies (and the lack of liquidity on many of them results in increased volatility) and the depreciation of these currencies in comparison to reserve currencies, chiefly the US dollar. 

Will this financial cycle lead to a full blown emerging country crisis?

Compared with the previous crisis in the developing and emerging countries or the Euro crisis (which offers troubling similarities), chances are that the current market reversal will have limited consequences.
 

- The first reason is that the very nature of financial flows toward emerging countries has changed. The biggest share of it now consists of foreign direct investment (FDI). Foreign direct investors do not generally speculate on short term currency appreciation and the assets they have bought or created in the emerging countries are most of the time illiquid. Hence a precipitated withdrawal is not possible. However, this must be nuanced since many companies use the FDI channel to invest short term, through accounting tricks. This is especially the case, it seems, in China where short term capital flows are still under a rather strict control but where the huge stock of foreign direct investment makes it relatively easy to cheat.

- The second reason for cautious optimism is that the volatile capital inflows are mostly invested in domestic currencies securities. Hence, the exchange rate risk relies on the shoulders of the investor and not the beneficiary of the investment. However, it is likely that for the past few months, countries the current account deficit of which is increasing have faced greater difficulties to find foreign investors who are willing to accept to invest in local currency. It is therefore possible that short term bank loans in international currencies have made a discreet comeback.

- Third, though still not perfect, the ability of the international community and individual countries to manage a crisis and to prevent its spreading has improved. The lessons of the 1990s and early 2000s crisis have not been forgotten. Many countries have built up impressive stock of foreign exchange reserves that will help them to counter excessive outflows. In addition, the temporary restrictions on capital outflows is no longer a taboo. These tools were used during the 2008 crisis to prevent outflows, notably by Iceland, and in 2009-2010 to prevent excessive inflows (e.g. Brazil, Taiwan).  Monetary policy has become the realm of creative thinking and solutions that were not even thought about 15 years ago can emerge very quickly. Already the Fed has de facto played a role of global lender of last resort during the 2008-2009 crisis including to some emerging countries. Regional and bilateral monetary agreements have developed, especially in Asia. Finally, the IMF stance on many issues has changed dramatically. IMF has moved from a free market neo classical orthodoxy in the 1990s to a more pragmatic type of neo-keysianism. It has incorporated a great deal of preventive dimensions in its financial facilities, increased its resources (though the doubling of its quotas, the resources that its members invest in the fund, which was decided in 2010, still has to be ratified by the US senate). The IMF has also proven that it can further increase quickly its financial resources through additional borrowings from its member states. It is also possible that it will further change by acknowledging that, in some circumstances, debt must be written off in an orderly manner.

Hence, there is cause for some optimism. But, one must stay very cautious. Many uncertainties remain to be clarified. Chiefly among them is the usual suspect: the black box of domestic and international finance. Despite very useful databases (such as the one the Bank for International Settlements maintains on the foreign exposures of banks), the amount of risk that is born by financial intermediaries in the western world is hard to measure precisely. The consequences of such a crisis on financial intermediaries in emerging countries remain to be evaluated.

And this is not to mean that the emerging countries that are challenged today will easily find their way back to a high pace of growth. The unbalances that have emerged will have to be overcome (insufficient investment, excessive current account deficits, the rising middle class dissatisfaction) while the comfort of over-appreciated currencies and abundant capital inflows will have