Firing Up Emerging Market Contagion

by: Desmond Lachman

At this time of acute stress in the Argentine and Turkish currency markets, a devastating fire at Brazil's National Museum was the last thing the emerging market economies needed.

Firefighters try to extinguish a fire at the National Museum of Brazil in Rio de Janeiro, Brazil, September 2, 2018. Reuters/Ricardo Moraes

By further tarnishing Brazil's political elite and heightening public resistance to budget austerity, this weekend's fire at a Brazilian iconic establishment is all too likely to increase the chances that Brazil will become the next emerging market domino to fall. If that were to occur, there would be little hope of preventing the same sort of emerging market contagion that we saw in the 1998 Asian currency crisis.

Already prior to this weekend's fire, the Brazilian real had lost around 20 percent of its value. It did so as investors began to focus on Brazil's contentious presidential elections that are to take place in two rounds on October 7 and October 27. It also did so as investors became increasingly concerned about Brazil's shaky public finances as epitomized by a budget deficit of around 8 percent of GDP and a public debt of almost 85 percent of GDP.

The public anger at the Brazilian political elite for budget cutbacks that exposed the National Museum to the sort of disaster that took place would seem to be the kiss of death to any hope that Brazil's centrist political parties will do well at the forthcoming elections. This is especially the case considering how badly damaged those parties already were as a result of the Petrobras (NYSE:PBR) scandal. Worse yet, the fire is likely to highly complicate any attempts by a new Brazilian government to introduce the much-needed pension reform and to introduce other budget belt-tightening measures to restore order to the country's public finances.

Unlike Argentina and Turkey, as the world's eighth largest economy, Brazil's economy is of systemic importance and has the real potential to cause emerging market contagion. Beyond being more than two and a half times the size of either the Argentine or Turkish economies, the Brazilian economy has a public debt that amounts to around US $1.5 trillion. Any large losses on that debt, coming after similar large losses on Argentine and Turkish debt, is bound to lead to generalized investor disaffection to the emerging markets as an asset class. That would breed the kind of contagion that we saw in the 1998 Asian currency crisis.

Hopefully, Federal Reserve Chairman Jerome Powell is paying close attention to Brazil's unfolding economic crisis. Maybe then the Fed will not get caught flatfooted in responding to an emerging market crisis that has the potential to derail the global economic recovery.