Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.â€
In 2005-6 the consensus among leading international policy makers, including the finance ministers who make up the governing body of the International Monetary Fund, was that economic and financial crises were a thing of the past. The United States and Europe had evolved beyond the potential for serious instability, and middle-income emerging markets had learned hard lessons from their experience over the previous decades, so their policies would be much more careful going forward. Serious crises, if they occurred at all, would be limited to war-torn, low-income countries.
This view was completely wrong. We are now partway through a full cycle of crises, beginning with the United States (from 2007) and Europe (from 2008 in earnest). It is now the turn of emerging markets to face real problems, including India, a country that experienced great and long overdue success for 20 years.
There are several types of emerging market crisis. One of the more common varieties starts in the following manner. There is a boom, based on natural resources or finding new niches for manufacturing exports or even implementing sensible liberalization measures. The private sector expands and more prominent companies find it increasingly easy to borrow overseas. Dollar (or other foreign currency-denominated) loans become attractive because they carry a lower interest rate than does borrowing in domestic currency.
International investment banks beguile the local elite - the economic and political people who make policy decisions - with stories of how their country and the world has changed, so it makes sense to borrow more. This is not a hard sell. Policy makers want to believe they have found the special elixir of economic growth and, in recent years, to believe they have “decoupled†from the prolonged recessions and slow growth in the United States and Western Europe.
And issuing debt - “increasing leverage,†in the jargon - feels like alchemy during good times. If you put less money down to buy an asset (i.e., less equity and more debt in your purchase) and the asset appreciates in value - then you have a made a great return on your equity. But you are almost certainly not thinking about risk-adjusted returns, i.e., what happens when asset prices fall. Less equity means the value of your debt will exceed the value of your asset that much sooner.
Put all this together, and you have a classic recipe for vulnerability. Capital inflows (borrowing overseas plus foreigners coming into the local stock market) tend to keep the exchange rate more appreciated than it would be otherwise. This encourages imports and discourages exports, so it is easy to develop a current account deficit (meaning that the country buys more goods and services from the rest of the world than it sells).
This is sustainable as long as the capital continues to flow in - particularly as long as companies can issue debt in dollars. But as John C. Bluedorn, Rupa Duttagupta, Jaime Guajardo and Petia Topalova of the I.M.F. point out in a new working paper, “Capital Flows Are Fickle: Anytime, Anywhere,†at least since 1980 “private capital flows are typically volatile for all countries, advanced or emerging, across all points in time.â€
No one is immune from the fickle nature of credit in the world economy. International banks love countries until about five minutes before they start trashing them to clients - for example, because they feel (as now) that growth in China and other emerging markets is definitely slowing.
Shifts in sentiment are unavoidable. The question is: how leveraged are you when this happens and how much debt do you need to refinance while markets are feeling negative about your prospects?
While the generic description above is a helpful framework, the Indian situation has important special features, as Devesh Kapur of the University of Pennsylvania and Arvind Subramanian, my colleague at the Peterson Institute for International Economics, have stressed. In particular, policy makers have not made the mistake of trying to cling to a fixed exchange rate (i.e., there is no explicit commitment to peg the rupee to a precise rate relative to the dollar).
As a result, the rupee is able to depreciate without too much drama, and this by itself should, over time, help to reduce imports and increase exports. India’s foreign debts are mostly private, and the government’s fiscal position, while not strong, is also not as weak as seen in Latin America in the 1980s or some European countries more recently.
(To be precise: there is a large annual budget deficit - the headline number is around 9 percent of gross domestic product - but recent growth and a significant degree of inflation mean that debt relative to G.D.P. is projected to be around 66 percent by the end of 2013. This is gross debt, as reported in the I.M.F.’s latest Fiscal Monitor; the I.M.F. does not compile data on net government debt.)
Indian foreign exchange reserves remain at relatively strong levels, at least in comparison with past crisis experiences elsewhere.
This is not to play down the pressures. The effect of exchange rate depreciation is to push up domestic inflation, in part because much of India’s oil is imported (and world oil prices are in dollars, so depreciation immediately pushes up the domestic price in rupees).
Weakening confidence in the Indian economy has been compounded by some policy confusion in recent months, which has further encouraged domestic residents to move funds out of the country. But the central bank’s signaling of its intentions is likely to become clearer, with some tightening of policy, including modest interest rate increases, following the appointment of Raghuram Rajan as the new central bank governor. (I worked for Mr. Rajan in 2004-5, when he was chief economist at the I.M.F., and I was his successor in that position.)
Still, there is political pressure to keep the economy growing ahead of elections in early 2014, so we should not expect fiscal policy to tighten. And if the Federal Reserve does indeed tighten monetary policy in the United States - currently referred to as “tapering†its purchase of bonds - that will tend to push up interest rates and is likely to attract more capital out of emerging markets.
The Fed’s mandate is, by law and by convention, to worry about the United States economy, although officials in Washington are willing to provide outside assistance when things get sufficiently bad (e.g., the dollar funding provided to European banks, directly and indirectly, in the darkest days of 2008-9).
Terrence Checki of the Federal Reserve Bank of New York got it half right when he said recently, “Fundamentals are fundamental,†and “experience suggests that one cannot overstate the importance of sound economic management, strong fiscal positions, credible proactive monetary policy and rigorous financial-sector oversight.â€
He was talking about the American perspective on what emerging markets need to do - and the trajectory that countries like India must convince foreign investors they are on.
Of course, Mr. Checki was not talking about the United States, where economic management is shaky, the fiscal position is weak (and another budget crisis looms in October), and monetary policy has struggled to keep up with dealing with the consequences of failed financial-sector oversight (an unfortunate development in recent decades, for which the New York Fed shares responsibility).
When the United States faces a serious crisis, as in fall 2008, the world becomes unstable and capital flows into the United States, because the dollar is the ultimate reserve currency.
When a country like India faces crisis, for domestic reasons but also perhaps because of what is happening in the United States, capital tends to flow out of that country and toward safe havens (like the United States).
You can wring your hands about this system as much as you like - and central bankers around the world have been complaining even more than usual in recent weeks. But this is the way the world works, and this is how it will work for the foreseeable future.
The message is borrower beware, always. As the United States heads toward its next crazy confrontation over the federal government’s debt ceiling, heavily indebted emerging markets face serious risks.
Amit Dave/Reuters 
