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History of crisis in emerging markets points to Euro´s unraveling

To investors and analysts, it would seem that the current crisis in Europe is unique in its origins and scope, but a thorough analysis of the events currently unfolding draws clear parallels to previous episodes of financial unrest that were endured by several emerging markets in the late 1990´s.
The crises in emerging markets were given folkloric names depending on the countries that were involved; commentators referred to the tequila, samba, tango, vodka, and dragon crisis. The affected economies experienced major currency devaluations that caused subsequent recessions, but with the exception of Argentina (which defaulted on its foreign debt), all economies were able to rebound following a period of structural adjustments. In every case, the effects of the crisis led to corporate bankruptcies  and higher unemployment, but the devalued currency improved competitiveness and eventually gave way to a recovery through higher exports.
Major similarities with the current state of affairs in Europe
The table summarizes the main macro indicators for Spain and Greece, the two countries currently in the eye of the storm
Current Account Deficit (% of GDP)
Debt (% of GDP)
From the figures in the table we can derive the following similarities with past crisis:
1.       Overvalued exchange rates
All of the emerging market crises had as a common denominator the existence of fixed exchange rate regimes. These policies led to overvalued exchange rates generating large current account deficits. While the Euro is a freely floating currency and has already depreciated against the dollar by more than 15% this year, it is still highly overvalued if seen in the light of the Spanish and Greek economies, which have large current account deficits.
Unfortunately, it is unlikely that the rate of depreciation of the Euro will be enough to correct these imbalances. This is because the single currency is shared with economies such as Germany and the Netherlands which run large current account surpluses and prefer a more stable exchange rate .
2.       Loss of competitiveness
This is a direct consequence of having an overvalued currency, and is reflected in high unemployment, with Spain currently posting the highest unemployment rate of OECD countries at 20%. The IMF has stressed the need for labor market reform and has asked both Greece and Spain to take urgent measures in addressing the issues.
As mentioned above, in the case of emerging markets once the devaluation came the problems of high unemployment and large trade deficits were resolved as competitiveness was automatically restored, albeit with a big loss of wealth on the part of companies and individuals.
3.       High leverage financed by the inflow of foreign capital
In order to finance a current account deficit it becomes necessary to import foreign capital, which should ideally be invested in productive sectors that help to increase a country´s competitiveness. However, this inflow of liquidity can mask serious deficiencies in the recipient´s economy.
In the case of Spain, foreign capital in the form of loans to the banking sector was put to use in the real estate market. This created a huge bubble that has crippled the savings banks (cajas) with billions of non performing construction loans. In Greece, public debt has been used to finance a bloated government and early retirements.
How will the Euro crisis be resolved?
All emerging markets crisis reached a point when Central Banks ran out of dollars and had no choice but to devalue the currency. In the case of the Euro, the currency will continue to depreciate vs the dollar, but most likely it will not be enough to restore competitiveness for the southern countries.
Wage and asset price deflation, along with higher taxes and lower public deficits are the medicine currently being prescribed in all of Europe, and growth will suffer. We are already seeing signs of social unrest expressed in protests by angry trade unions, and this environment will make it tough for politicians to maintain restrictive policies in the long term.
Eventually, governments in the affected economies will have to leave the monetary union and remove the Euro strait jacket. There will certainly be painful adjustments to come, but history has proven that an unsustainable financial path for countries, like for companies and individuals, cannot be held indefinitely. The day of reckoning always comes, thus the present efforts and piece meal adjustments geared towards calming the markets will simply delay the inevitable. Let´s hope the climax of this crisis comes sooner rather than later.

Disclosure: The author does not hold a long or short position in the market