What has caused the sudden anxiety attack that overwhelmed financial markets after the New Year? We may find out the answer at 8.30 on Friday morning, Eastern Standard Time.

Almost all agree that the market turmoil has been linked to alarming events in several emerging economies — including Turkey, Thailand, Argentina and Ukraine — that has spilled over into concerns about more important economies, such as China, Russia, South Africa, Indonesia and Brazil.

But why has near-panic hit so many emerging markets at the same time?

There seem to be four broad explanations. Whether this current volatility marks the end of the straight-line ascent in asset prices that started in March 2009, or whether it is just another opportunity to “buy on dips,” will largely depend on the relative importance of each of these factors.

Most headlines about the emerging market instability blamed China — especially a plunge in Chinese economic statistics released New Year’s Day.

If China is really the main cause, investors can relax. Not because China’s weakness and credit tightening is an illusion, but because virtually every business and investor in the world has been aware of the Chinese slowdown for more than a year now. And so has Beijing.

The Chinese authorities, having achieved the slowdown and credit tightening they were seeking, now have both the tools and the willingness to keep credit from tightening much further and growth from falling significantly below the recent pace of roughly 7 percent.

The second explanation of the turmoil has been the tightening of global credit conditions due to the U.S. Federal Reserve’s December decision to “taper” its program of printing money and buying bonds. This is another threat that is more apparent than real.

Financial conditions have certainly deteriorated in many emerging economies. But to blame this on a global tightening of credit makes no sense. The Fed is still printing new money at a rate of $65 billion monthly, while the Bank of Japan is expanding its balance sheet by an average of $58 billion each month — with a strong possibility that even more aggressive monetary expansion will be announced in the next few weeks.

More important, it is now clear that short-term interest rates will remain near zero in the United States, Japan and Europe until well into 2015. As for long-term interest rates, far from rising on expectations of tighter monetary conditions from 2016 on, have fallen sharply since the end of last year. So it is impossible to blame this financial turmoil on tightening credit or fears of an increase in U.S., European or Japanese interest rates.

If credit in the developed world is still abundant and interest rates falling, why is the tide of global capital flowing out of so many emerging economies? The answer may lie in two problems that are actually more worrying than either the Chinese slowdown or Fed tapering.

The biggest threat to emerging economies is flight of domestic capital — as savers and businesses inside these nations lose confidence in the safety of their savings, the integrity of their currencies or the stability of their political systems.

When domestic capital starts to flee, the outflow can quickly overwhelm apparently strong policy defences, such as foreign exchange reserves, monetary tightening or apparently healthy trade accounts. As this capital flight accelerates, more domestic savers lose confidence in their governments, leading to more capital flight and then even greater economic and political instability.

This vicious circle of financial panic leading to political instability can quickly degenerate into death spirals that end with revolutions and military coups. A pattern familiar from many EM politico-economic crises.

But before getting too apocalyptic, we should remember that such vicious circles can also reverse and turn into virtuous circles — often in response to quite small improvements in domestic policies and global economic conditions.

Which brings us to the last possible explanation of the recent scary market dynamics.

Perhaps the main reason for the sudden swing of the global financial pendulum from greed back to fear has been the deterioration in U.S. economic data that started with the shockingly weak U.S. payroll employment report of January 10.

Economists dismissed that report as an aberration, due to exceptionally cold weather. It was indeed inconsistent with most other data — such as last week’s gross domestic product figures, which showed strong U.S. growth in the fourth quarter, despite the government shutdown. The private sector expanded at a boom-time rate of 5.1 percent.

But despite such conflicting evidence, many investors have chosen to follow the aberrantly weak payroll figures — though few people believe them to be accurate.

This should not be surprising, however. Financial markets are driven not just by what investors believe, but also by what investors think other investors believe.

As I have often pointed out in this column, the monthly U.S. employment figures have largely determined the direction of financial markets the world over since mid-2009. After the 2008 Lehman Brothers crisis, it seems that investors have simply not been prepared to believe in a global economic recovery unless they could see evidence of strong U.S. job growth.

It is therefore possible that decent U.S. employment figures are a key condition for financial confidence to be restored — not just on Wall Street, but also in Istanbul, Moscow and Sao Paulo.

The next U.S. employment figures are due out at 8.30 on Friday morning. So we will soon find out if this simplistic-sounding theory makes sense.



Anatole Kaletsky is an award-winning journalist and financial economist who has written since 1976 for The Economist, the Financial Times and The Times of London before joining Reuters.