Developing nations likely in the eye of the financial storm

It’s tempting to declare this year’s perfect storm for many emerging economies over.

The international market combination of particularly painful price moves  — that of oil price increases, higher interest rates and a stronger dollar — has eased for now; and Wednesday’s IMF approval of a large financial program for Argentina is a reminder of the existence of timely and significant international assistance.

{mosads}Yet it’s way too early to declare victory. Rather than smooth sailing, both emerging countries and the international system should brace themselves for the probability of some further volatility.

It is only a few weeks since both Argentina and Turkey were in the midst of significant currency turbulence that undermines economic growth, prosperity, overall financial stability and social cohesion.

The immediate cause of this was concern about larger deficits due to the rising price of energy imports, more burdensome borrowing costs due to higher interest rates abroad and capital outflows as investors sought to reduce losses on account of a dollar appreciating vis-a-vis the local currencies.

For both countries, and for several other vulnerable emerging economies, this combination of external influences exposed domestic weaknesses and amplified the threat of a vicious self-feeding cycle of financial, economic and political disruptions.

As such, many observers have rightly welcomed the more recent fall in oil prices and the moderation of interest rates. Add to that a $50 billion headline-grabbing IMF program for Argentina, including a sizable immediate disbursement of $15 billion, and it’s tempting to declare the emerging market scare over. But that could well be imprudent, and also premature, due to two major reasons. 

First, it is far from inconceivable to expect international markets to reproduce turbulent conditions for emerging markets. 

Granted, oil prices could head even lower due to supply pressures, both internal and external, on OPEC to relax production limits and because of the coming on stream of higher non-traditional sources (including shale).

But prospects for interest rates are still for higher levels as U.S. growth continues to outpace other advanced countries and as the Federal Reserve delivers on its signals to raise interest rates more. And this is a combination that also supports further dollar appreciation.

The second reason relates to what economists call “initial conditions.” 

Emerging markets started this year with a sizable technical vulnerability, and it’s not a new one. Over prior years, and repeating a pattern seen many times earlier, lots of foreign capital had headed their way.

But, rather than “pulled” by an understanding of EM’s attractiveness and prepared for the inevitable up-and-down of investing there, a significant portion was “pushed” out of advanced countries by low interest rates there.

Away from its natural habitats, this capital is quite flighty; and it will likely continue to reverse direction for at least a few months.

While emerging economies should certainly hope for a smoother environment, they would be well advised not to plan for that. A more probable outcome includes bouts of volatility.

This means doing all that they can to reduce internal vulnerabilities, including stepping up economic reforms, reducing refinancing needs, dealing with debt maturity mismatches and avoiding excessive naked foreign currency positions.

This should also serve as a reminder to advanced countries, especially in Europe, of the need to do more on their side to promote economic growth and financial stability.

The international system cannot rely on the emerging world to couple with the U.S. as major engines of global growth — and this is before you factor in uncertainties about trade.

If anything, recent developments highlight the importance of the “adding up” challenges for the global economy and financial markets, accentuating the need not only for pro-growth measures but also for reforms to the multilateral system.

Mohamed El-Erian is the chief economic adviser of Allianz and former CEO of PIMCO. He is a frequent guest on CNBC and a contributing editor to the Financial Times. He has written two New York Times Best Sellers: “The Only Game in Town: Central Banks, Instability,” and “Avoiding the Next Collapse.”