The recenT Turmoil

in emerging economies Since early 2014, heightened volatility in international financial markets has hit emerging economies hard. In the year leading up to 5 March 2014, emerging economies saw about US$30 billion in equity outflows, which was twice as much as the total outflows for the whole of 2013 (Reuters, 2014a and 2014b).1 This latest turmoil occurred only a few months after emerging economies were battered by sudden capital reversals, caused by the Chair of the United States Federal Reserve hinting (in May 2013) that the Federal Reserve would begin reducing quantitative easing. This has come as a surprise to many observers and analysts who had, since the financial crisis of 2008, suggested that emerging economies had “decoupled ” from trends and policies in advanced economies. The worry now is that having missed the warning signs, emerging economies will be on the receiving end of the wrong diagnosis if there is a more dramatic turn for the worse, with inappropriate remedies likely to follow. old wine, new bottles? The reaction of financial analysts and pundits to recent events is somewhat perplexing given that the underlying story is a familiar one. Since the end of the Bretton Woods system, developing countries have been subject to a series of financial shocks and crises associated with boom-and-bust cycles in private capital flows. Booms are generally driven by an increased global appetite for risk and low interest rates in source countries. Thus asset bubbles and interest-rate differentials attract liquid and short-term capital flows which initially reinforce confidence in the stability of the exchange rate. The newly deregulated banking sector expands into new areas of domestic business, and domestic firms borrow abroad to take advantage of lower interest rates, thereby exposing themselves to exchange-rate risks. With growing economic imbalances come heightened financial fragility and uncertain expectations. In the bust phase triggers tend to be varied, but a change in the policy stance in source countries has often been involved. This leads to a rapid outflow of capital and increases the probability of a severe crisis as a result of a falling exchange rate and rising interest rate which threatens corporate bankruptcies and the solvency of domestic banks