As the Prime Minister said on his way to the Group of Twenty (G-20) meeting last week, although emerging markets bear no responsibility for the current global crisis, they have been hit very hard because of it. But this is not the first time that emerging markets have suffered through no fault of their own—recent research shows that the Asian crisis, too, may not have been their fault.

In other words, contrary to most of the received wisdom about the Asian crisis that laid the blame for the crisis on Asian economies, Calvo said the evidence showed that both the huge capital inflows into these economies and the subsequent outflows pointed to them being passive in the entire drama. While others blamed crony capitalism, high levels of debt or the pegged exchange rates of Asian economies as the reason for the crisis, Calvo said the origins of the crisis did not lie within them. He, therefore, suggested the creation of an emerging market fund that could be used to stabilize an index like the JPMorgan Emerging Market Bond index, whenever its spreads go above a certain level. Note that a proposal currently being advocated by India is to set up a $200 billion (Rs9.94 trillion) emerging market fund, with the US expected to foot the bill.

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In fact, there exists vast literature on “sudden stops" of capital flows to emerging economies. A Bank for International Settlements working paper by Calvo, Alejandro Izquierdo and Ernesto Talvi, titled Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crises, has a list of emerging markets affected by systemic collapse episodes and finds that, for a total of 83 episodes, the average contraction was 7.8%, although there is a large concentration around small drops in output.

But research shows that recovery is usually V-shaped, which means the economy gets back to normal within a short span of time. As the researchers point out, “These episodes are characterised by two salient features. First, there is a dramatic collapse in output accompanied by a collapse in credit, but without any correspondingly sharp collapse in either physical capital or the labour force." Second, recovery to pre-crisis output is swift and “creditless"—output grows back to pre-crisis levels without a significant recovery in domestic or external credit. Thus, although a credit crunch appears to be central for explaining output collapse, recovery can take place without credit. This phenomenon, resembling the feat of the proverbial bird, “rising from its ashes prompted us to call it Phoenix Miracle". Investment falls together with output, but recovers feebly as output rises, thereby lowering demand for credit.

The trouble is, during previous emerging market crises, they could fall back on exporting their way out of them, simply because the developed world was unaffected by the crisis. That comfort no longer exists. Recent data show that US retail sales have fallen for four consecutive months now, with a record drop of 2.8% in October, a clear indication that the US consumer, the Titan holding up the world economy and the lynchpin of the Bretton Woods global economic system, is finally on the brink of collapse. There is, thus, no alternative for emerging markets to prop up domestic demand. Richard C. Koo, chief economist at Nomura Research Institute, Tokyo, in his book The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, outlines the summary of the cycle: “Overconfident private sector triggers a bubble—monetary policy is tightened, leading the bubble to collapse—collapse in asset prices leaves private sector with excess liabilities, forcing it into debt minimization mode. The economy falls into a balance sheet recession—with everybody paying down debt, monetary policy stops working. Fiscal policy becomes the main economic tool to maintain demand—eventually private sector finishes its debt repayments, ending the balance sheet recession. But it still has a phobia about borrowing which keeps interest rates low, and the economy less than fully vibrant. Economy prone to mini-bubbles—private sector phobia towards borrowing gradually disappears and it takes a more bullish stance towards fund-raising—private sector fund demand recovers and monetary policy starts working again. Fiscal policy begins to crowd out private investment. Monetary policy becomes the main economic tool, while deficit reduction becomes the top fiscal priority—with the economy healthy, the private sector regains its vigour and confidence returns." The world is currently at the “monetary policy stops working" stage.

Unfortunately, countries such as India do not have much leeway for fiscal expansion.

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at