Mohamed El-Erian dissects the emerging market trilemma

10 Apr 2023 , 08:41 AM

In a freewheeling conversation with World Bank President (David Malpass), the entire issue is dissected in detail by Dr Mohamed El-Erian. While Erian needs no introduction, he was formerly the brain behind PIMCO, one of the world’s largest dedicated debt funds. He is regarded globally as an authority on bond markets, interest rates, currencies, and macroeconomics. Here is the Dr Mohamed El-Erian prescription.

What exactly is the trilemma for emerging markets?

Dr Mohamed El-Erian himself admits that there is a growth problem, despite the fact that most of the emerging markets navigated the COVID crisis pretty well. In a recent report, World Bank had pointed out that the potential of the world economy to grow had fallen to the lowest since the year 1990. This lower growth assumption is based on the troika of factors viz. rising inflation, weakening currencies and stagnant growth. It is this trilemma that emerging markets have to resolve. According to Dr Mohamed El-Erian, the world needs to rethink growth models due to the combined impact of energy, digital, and science. In addition, Dr Mohamed El-Erian feels that global economies had learnt a lot about what to do and what not to do, but was not incorporating these lessons fast enough. 

Much of the problem emanates from the US

In the words of Dr Mohamed El-Erian, much of the problems that emerging markets are facing today is due to the US, since it is the US economy that is at the core of the global system. The US, according to Erian, has a flow problem and a stock problem. For example, the US Federal Reserve massively expanded its balance sheet post 2020 from $4 trillion to $9 trillion. The ECB balance sheet contributes another $8 trillion, so there is just too much liquidity sloshing around. According to Dr Mohamed El-Erian, when inflation first reared its head about 18 months back, the US Fed should have ideally rushed in to tighten. That would have, perhaps been a lot more effective. As he puts it very succinctly, the US was the core of the global financial system and the core was not run the way it should be run.

Dealing wrongly with inflation

According to Dr Mohamed El-Erian, the Fed was wrong on two fronts. Firstly, the Fed totally mis-characterized inflation in 2021. Secondly, once they recognized that they had actually mis-characterized inflation, the Fed just did not act fast enough. For instance, Jerome Powell continued to call the problem of inflation transitory as late as November 2021. This became an anthem across global central banks and that is where problems started. However, the second part of the problem, according to Dr Mohamed El-Erian, was that even after recognizing that inflation was not transitory, the Fed continued to keep rates at zero and infuse liquidity till as late as March 2022. In short, the action from the Fed came too little and too late and when the momentum actually picked, the damage had been done.

Not seeing the writing on the wall

Dr Mohamed El-Erian believes that in most cases it was a case of not seeing the writing on the wall. For instance, the erroneous belief was that post-pandemic there would be a demand problem, not a supply problem. That view was not changed even after contrary data flowed in. Since demand was supposed to be the issue, inflation was never taken seriously. The big transition was the energy transition and that was inherently inflation driving. Also, the assumption was that labour would be abundant and jobs had to be created, but in reality, labour supply turned out to be scarce. Above all, the supply chains had to be rewired after the indifference shown by China. But then, rewiring supply chains itself is inflationary. All these trends were misjudged and not changed in line with data.

What this emerging market trilemma was all about?

Most of the emerging market had 3 contrarian factors pulling. For instance, they had to maintain growth but they also had to maintain price stability (inflation control). All this had to be done even while maintaining financial stability. With this kind of trilemma, policy and execution mistakes were inevitable. On the crisis in venture finance and banks, Dr Mohamed El-Erian feels that much of the euphoria was led by the greater fool theory. Normally, individuals buy assets and investments based on potential future value. Here, the liquidity from rich nations was so much that investors would buy assets with the confidence that all the liquidity would eventually lead to asset inflation. The whole theory fell flat only when this assumption was disrupted by a few crisis moments. 

Most emerging markets need to evolve and adapt

To paraphrase Dr Mohamed El-Erian, just because an emerging market is successful today, does not mean it will continue to be successful. The problems never arise from shortage of resources but from failing to get the buy-in for change. Erian gives the example of IBM, which was so insanely successful, but lost out the market cap race just because it did not evolve as a technology organization. More often than not, it is about decision making inertia, or what is called active inertia. Today, most of the emerging markets blame external constraints or the actions of developed markets. In reality, in most cases, the problem is internal to these emerging markets. That is where pushing for change and getting buy-in for such change becomes critical. That is the way to solve the tough macro challenges.