Emerging Market Bail Outs

As if Western governments and central banks weren't spending enough (some $7 trillion and counting) to prop up their sickly financial sectors and ailing economies, they are now having to bail out the rest of the world, too. In October, the Federal Reserve set up an unprecedented $120 billion credit line to Brazil, Mexico, Singapore and Korea to stave off a liquidity crisis in those countries. The European Central Bank has helped struggling Hungary with $7 billion, while Iceland and Latvia have stayed afloat only thanks to handouts from nations like Britain, Sweden and Germany. In December, the U.S. Treasury set up a joint $20 billion fund with China to keep global trade financed as Western bank loans to emerging markets dry up. All this comes on top of an accelerated pace of IMF emergency bailouts that have included, so far, Pakistan, Ukraine, Hungary and Iceland.

Clearly, Western governments are worried that the typhoon now hitting the emerging markets will loop back to an already weakened United States and Europe. So much for the theory that developing nations would "decouple" from the crisis, let alone help pull the West back out of recession. Instead, the meltdown in the rich countries' financial sector has hit emerging economies hard, and in many places at once: declining trade, cutbacks in foreign direct investment, lower remittances from citizens abroad. Portfolio investments have reversed as Russian and Indian investors seek "safe havens" in Western currencies and treasury bonds. As a result, the World Bank estimates the total flow from West to East in 2009 to collapse to half the 2007 peak of $1 trillion.

All this comes at the worst possible time—developing countries have a record $620 billion of long-term debt and interest coming due in 2009. Drowned in the emerging-market euphoria of recent years was the fact that, except for China and a handful of other surplus countries like the oil exporters, developing countries are still very much dependent on inflows of Western capital. This time, however, overextended Western banks are unable to supply it, as they struggle with their own painful deleveraging. What's more, Western governments are expected to issue $3 trillion in government bonds in 2009, three times the 2008 level, to finance their ever larger stimulus spending programs. According to Independent Strategy, a London consultancy, emerging market countries will face a combined financing shortfall of $570 billion in 2009—down from a capital surplus of $880 in 2007. The countries most at risk of a payment crisis, according to Neil Sharing of Capital Economics in London, include the "super deficit" countries in Eastern Europe and Central Asia, as well as some countries in Latin America like Ecuador, which went into default on its international debt in December. Argentina could be next.

It's unlikely that there is enough money to go around. The IMF has a stash of $200 billion and an arrangement allowing it to call on its members for another $50 billion, but that is far short of the $570 billion needed. Unless the pace of bailouts picks up dramatically, the most probable scenario is an even steeper plunge in emerging-market assets, deep recessions and declining currencies, according to Independent Strategy's David Roche.

The most strategically important emerging markets will be the most likely to receive help. The Fed and ECB have recently stepped forward as additional lenders of last resort, attempting to "ring fence" their most valuable trading partners in the hope of limiting the damage at home. Expect European governments to continue bailing out selected countries in Eastern Europe. The Fed has supported important allies and trading partners in Latin America and Asia. China has bailed out its ally Pakistan, and last week offered loans to help firms in Taiwan weather the crisis.

How effective will these bailouts be? Just like in the West, they can soften, but not eliminate, the wrenching changes taking place as the world switches from an oversupply of credit and leverage to an age of saving and thrift. That's because much of the emerging-markets business model—of the Asian factory economies and the commodity exporters like Australia or Brazil that supply them—was built on overleveraged Western consumers buying more developing-nation products than they could afford. The eastward rush of investment, too, was in part a product of all the cash sloshing around thanks to the Western credit bubble. With America and the West entering into a less free-spending era, that model appears no longer sustainable. At best, the other bailouts will help some countries smoothen the transition.