Tuesday, October 28, 2008

Problems Facing Emerging Economies

A feature of the current financial crisis is how hard it has hit supposedly 'strong / safe economies' like the US, UK, Europe e.t.c. However, now attention is switching to emerging economies and the potential problems they are facing.

Problems Facing Emerging Economies.

Large Current Account deficits.

Iceland had a current account deficit of 7% of GDP. South Africa has a current account deficit of 7.7%. Basically, this means they are importing more goods and services than exporting. To finance this current account deficit, it is necessary to attract capital inflows (either hot money flows or long term capital investment e.g. Foreign firms investing in India.)

The problem is that the credit crunch has made it more difficult to attract sufficient capital flows. Even Russia, which has a current account surplus requires capital flows, but, they are now struggling to attract sufficient funds.

If a country cannot finance its current account deficit. A depreciation becomes almost inevitable. This was one reason for the depreciation of the Icelandic Krona. It is why the South African Rand and Hungarian Florint are depreciating.

Depreciating Exchange Rates

A depreciation in the exchange rate does make exports cheaper. But, it also makes imports more expensive and the repayment of foreign debt more difficult. When a currency depreciates, a country struggles to repay its external debt and therefore investors lose confidence in the economy causing a further depreciation. - It is a vicious circle. Also a depreciation in one currency can have an endemic effect on nearby economies. E.g. depreciation in Thai Bhat in 1998 precipitated a wave of falling currencies it become known as the Asian Crisis of 1998. The concern is that a depreciating Hungarian Florint could spark a wave of speculative selling for nearby Eastern European currencies.


In economics we keep coming back to this issue of confidence. In the financial sector, confidence is everything. The problem is that as emerging economies face difficulties investors give bad credit ratings to these economies. Because there is a deterioration in the credit worthiness of the economies, they are forced to increase interest rates to
  • Protect their currency
  • Encourage people to buy their now 'risky' government bonds.
Hungary recently had to increase interest rates 3% to 11%. Higher interest rates are very damaging for the economy causing lower growth. (Just imagine if the UK had to increase interest rates 3% at the moment?)


Many Hungarians took out loans and mortgages in Swiss Francs. This seemed attractive because Swiss interest rates were lower. However, now the Hungarian Florint is depreciating, loan repayments are increasingly drastically.

Government Borrowing

High levels of government borrowing mean interest rates may need to be higher. It is also a particular problem if the government finances its debt by selling to other countries.

Basically, emerging economies have many similar problems to UK and US, they have borrowed too much and overextended themselves. The problem they face is that there governments may have less resources to intervene and guarantee the banking system. It may require concerted international action to intervene.

No comments: