Brazil fights capital inflows (2009)

An unprecedentedly low level of interest rates in the advanced economies has triggered a massive surge in capital flows to emerging markets. In order to stem further currency appreciation, Brazil has stepped up FX intervention and introduced a tax on capital inflows. Should capital inflows persist and the exchange rate remain under pressure, the central bank may well opt for greater FX intervention, not least in order to pre-empt potential threats to its autonomy. Should the central bank resist greater intervention, the government may feel compelled to choose between curtailing the autonomy of the central bank and tightening capital controls.

Nouriel Roubini has called it the “mother of all carry trades”. Unprecedentedly low levels of interest rates in the advanced economies and returning risk appetite have triggered a surge in capital flows to emerging markets (EM). Financially weak EMs will welcome the reflow of capital, but EMs with solid external fundamentals will feel more ambiguous about it. While the renewed inflows help ease financing conditions, especially for the private sector, the sheer size of the inflows and the resulting upward pressure on the exchange rate have raised concern about a loss of competitiveness and slower economic growth. EMs with (relatively) freely floating exchange rate regimes, open capital accounts and solid macro-fundamentals have experienced sharp currency appreciations (e.g. Brazil, South Africa).

Brazil provides an interesting case study in terms of the policy challenges this “sudden surge” in capital inflows poses to policymakers. In the face of large capital inflows and considerable currency appreciation, the central bank resumed FX purchases in May and increased intervention considerably in October. In addition, the finance ministry slapped a tax on portfolio inflows in October. These measures seem to have contributed to a stabilization of the real in the 1.7-1.8 range vis-a-vis the dollar.

Source: Banco Central do Brasil

But what will the authorities do if capital inflows increase further? If the currency is allowed to appreciate, the current account deficit will widen. While this would not be a problem given solid fundamentals (esp. limited foreign-currency mismatches, financing of the deficit through equity rather than debt flows), a rapidly rising stock of foreign portfolio investment would gradually raise Brazil’s vulnerability to yet another “sudden stop” – a prospect no government fancies less than 12 months before a major election. The government’s decision to “lean against the wind” (or storm, if you will) is therefore not surprising.

Brazil was heavily criticised for introducing a capital inflows tax. But what was the alternative? The textbook response would be to tighten fiscal policy in order to put downward pressure on domestic interest rates. However, politically, fiscal tightening is difficult to achieve given next October’s presidential elections. More importantly, economically, it is doubtful that fiscal tightening will solve the problem, for Brazil is experiencing an equity rather than a debt carry trade. In other words, it is Brazil’s relatively strong growth outlook rather than a large interest rate differential that is the dominant driver of capital inflows and currency appreciation.

Another policy option would be to step up FX purchases. Judging by the October data, the central bank already seems to have moved into this direction. If the current surge in inflows turns out to be temporary and reversible, increased sterilized FX intervention looks both financially feasible and politically attractive. This might require the government to order the central bank to step up purchases, should the latter be reluctant to increase the pace of intervention. Alternatively, the government could try to change legislation in order to allow the treasury to make larger FX purchases. However, if capital inflows turn out to be more persistent and permanent, this strategy will be less viable given rising sterilisation costs and the impact increased domestic bond issuance may have on interest rates.

Finally, the authorities could further tighten controls on inflows. Empirical research suggests that controls on inflows tend to be detrimental to medium-term growth and often fail to be very effective, especially in countries with a sophisticated financial sector. But controls do not have to be “very” effective to have an effect and, indeed, to make them politically attractive. Should the central bank balk at stepping up FX intervention, a tightening of controls cannot be ruled out. Currently, the government is studying measures aimed at liberalising capital outflows. But it is far from obvious that such measures will be effective in significantly reducing net capital inflows and currency appreciation, especially in the short term.

One of the prospective presidential candidates is known to have “unorthodox” ideas about how to manage the exchange rate, favouring a weaker exchange rate and lower interest rates with a view to generating “export-led growth”. The stronger the exchange rate in the run-up to and following the presidential elections, the more likely such ideas will gain currency. There is good reason to be skeptical about the likely success of such a “mercantilist” strategy, for as long as domestic investment remains low, a weaker exchange rate and lower interest rates will simply raise inflation and push up the real exchange rate; and in order to generate higher investment, the domestic savings ratio would presumably have to increase. But this is a separate debate.

The political and economic bottom line remains the following. Should capital inflows persist and the exchange rate remain under pressure, the central bank may well opt for greater FX intervention, not least in order to pre-empt threats to its autonomy. Should the central bank resist greater intervention, the current and future government may face a tough choice: curtail the autonomy of the central bank or resort to further “unorthodox measures” (read: capital controls). The government must no doubt be hoping not to have to make this choice. The reality is, of course, it doesn’t have to: it could simply let the exchange rate overshoot given solid fundamentals and manageable foreign-currency mismatches. However, even the IMF expresses some sympathy for (temporary) capital controls. Therefore, if capital inflows remain strong over the next few quarters, the government may find it difficult to resist a further tightening of capital controls.

Emerging markets and financial sector liberalisation (2009)

Emerging markets policymakers have come to regard the developed markets regulatory model as effectively broken and will therefore adopt a more cautious stance vis-à-vis financial sector liberalisation and deregulation. This does not mean that they will abandon plans for further financial liberalisation altogether; but they will undoubtedly pursue a more gradualist, selective and “homemade” approach to developing their financial sectors.

The worst economic and financial crisis since the Great Depression has caused remarkably little political instability. Although the full social impact of the economic downturn may not have been felt yet, the economic stabilisation currently underway carries the promise that serious political instability will be avoided altogether.

Neither has there been a shift towards more populist (less sustainable) policies since the beginning of the crisis. If anything, we will be witnessing a shift towards more prudent policies in crisis-hit countries undergoing IMF-supervised adjustment (e.g. CEE). As spelt out in a previous comment, emerging markets (EM) will likely be adopting more aggressive FX intervention policies, but a major change in macroeconomic policies is not on the cards. However, EM policy-makers have come to regard the developed markets (DM) regulatory model as effectively broken and will adopt a more cautious stance vis-à-vis DM-style financial sector liberalisation and deregulation.

Government ownership of banking assets: It will not have escaped EM policymakers that governments with direct control over (parts of) the domestic bank sector were able to alleviate (somewhat) the effects of the credit crunch (e.g. China) by counteracting what would otherwise have been very pro-cyclical lending behavior by the banks. This won’t lead governments to nationalise banks. However, it may lead them to increase the resources of existing public sector banks in order to boost their lending capacity (e.g. Brazil) and it will make them reluctant to relinquish control in the form of “window guidance”, public ownership and control of banking assets etc. Should the recent government-directed lending surge seen in some EMs generate a sharp rise in bad loans and fiscal losses, EM attitudes may change again. For now, greater government control over bank credit will appear attractive to many policymakers.

Foreign ownership of banking assets: Pre-crisis, the transfer of capital and management expertise from DMs to EMs in the form of foreign ownership of domestic banks was considered desirable. Today many EM governments, rightly or wrongly, will regard foreign ownership as more of a mixed blessing. Parent banks have shown a willingness to re-capitalise their local subsidiaries in some instances (e.g. Ukraine), thus contributing to banking sector stability. Anecdotal evidence suggests that foreign banks’ willingness to increase (or maintain) lending does not differ systematically from that of domestically-owned private-sector banks. 

However, even where foreign banks’ local operations are sufficiently liquid and capitalized, they often prefer to park their excess funds with the central bank rather than lend to the private sector (e.g. CEE). Nor is there evidence that the problems some parent banks experienced in their home markets has led to an above average cutback in their foreign on-shore lending (e.g. Mexico) – cross-border lending is naturally a different matter! Nonetheless, in the eyes of policymakers, this risk was real enough during the height of the crisis. Concerned about the possibility of “reverse contagion”, EM policymakers will be more selective and more cautious before further opening their doors to foreign banks, unless the need to recapitalize their banking sector combined with fiscal constraints does not leave them any choice (e.g. Iceland).

Domestic financial liberalisation: Not surprisingly, many EM policymakers have come to doubt the benefits derived from DM-style financial (de-)regulation. Most of the larger EMs have in place more restrictive regulations than their DM counterparts, ranging from higher capital requirements (e.g. Brazil) to restrictive regulation of various financial markets segments (e.g. China). Given the apparent failure of the DM regulatory model and the relative resilience of many EM financial systems during the crisis, EMs will be much less inclined to move forward along the lines of the DM model than before the crisis. This does not mean that they will abandon plans for further financial liberalisation altogether; but they will certainly adopt a more gradualist, selective and “homemade” approach.

Policymakers will regard the crisis as a once-in-a-lifetime event that hit EMs as innocent by-standers. In many cases, the DMs suffered more than the EMs and many EMs are emerging from the crisis more quickly than “over-leveraged” DMs. There is therefore little incentive for the EMs to fundamentally change macroeconomic policies. What the global crisis will do is make many EMs more cautious and selective when it comes to privatising, opening up and liberalising their financial systems along the lines of the DM model. Liberalisation will certainly not come to a complete halt, however. At the same time, DM governments will be in a weaker position to demand financial sector deregulation and liberalisation (e.g. US-China SED), while DM banks will be in a financially weaker position to purchase (relatively) more expensive and financially stronger EM banks. It will be interesting to see whether EM banks will take advantage of their improved position vis-à-vis their DM peers and expand in the DMs (or in other crisis-hit EMs).

Could Brazil become a model for poorly managed Latin American economies? (2009)

Brazil’s transformation from economic problem child to poster child is remarkable. The Lula administration’s key strategic insight was that lowering inflation and increasing economic stability, albeit at the expense of lower short-term economic growth, can be politically and electorally rewarding. What in 2003 may have looked like an emergency response to contain the financial crisis and avert a sovereign default has become the cornerstone of Brazilian economic policy and the main reason why Brazil is weathering the global crisis relatively unscathed.

Brazil’s transformation from economic problem child to poster child is remarkable. After averaging a mere 2.5% in the decade before 2003, annual real GDP growth picked up to 4.7% during 2003-08. Given global headwinds, it is doubtful that Brazil will continue to grow at this pace, but growth of around 4% over the next decade is achievable. After experiencing repeated crises throughout the 1980s and 1990s and as recently as 2002, Brazil’s economic and financial resilience is today almost second-to-none. Following Fitch and S&P, Moody’s is about to award Brazil an investment grade rating. True, the economy is forecast to contract slightly this year. But not only do the fundamentals remain strong, the economic contraction is also much less pronounced than in many other emerging and developed(!) economies and a return to sustained growth is just around the corner.

Brazil has come a very long way. In a previous comment, we attributed Brazil’s resilience and quick rebound to the reduction in foreign-currency mismatches, increased FX reserves and a disciplined fiscal policy. We perhaps should have added to the list the resilience of the banking system, the de facto independence of the central bank and a strong and credible commitment to economic stability. However, it is also a well-known fact that economic policies in the run-up to the crisis were far from optimal. It would undoubtedly have been preferable to contain the increase in current government spending, fuelled by buoyant tax revenues. This would have supported a more rapid decline in government debt and interest rates, thus allowing for a greater increase in private sector investment and faster economic growth. This might have helped to contain (if not avoid) the overheating pressures that emerged in 2004 and 2007 (and the subsequent monetary tightening in 2005 and 2008). Such a policy would also have given the authorities greater scope to pursue counter-cyclical fiscal policies today.

It is no secret either that the Lula I/ II administrations have been far less successful on the structural reform front. A limited public sector pension reform at the very beginning of Lula I has been the most eye-catching reform thus far, although several smaller reforms have been passed. The list of desirable structural reforms remains very long, including further pension reform, labour reform, central bank autonomy, tax reform, education etc. With the president’s second mandate drawing to a close, it is very unlikely that anything major will be achieved before the next president takes office in 2011.

Source: IMF

Why did macroeconomic reform take place, while microeconomic reform did not (or barely)? The answer to this question is multifaceted. First, the government has much more control over fiscal and monetary policy than over structural reform. Structural reform requires support from a great number of political “veto players”, including, most crucially in Brazil, a fragmented and difficult-to-control congress. Second, the political cost-benefit analysis made macroeconomic discipline much more enticing and rewarding than microeconomic reform. Tight macroeconomic policies cause short-term costs (economic growth) but also generate both short-term and medium-term benefits (increasing real incomes, especially among the poor, and greater economic stability). By contrast, microeconomic reforms cause a fair amount of short-term political costs and consume political capital (antagonizing well-organised, entrenched interests, typically forcing the government to compensate these groups in other ways), while the economic and political dividends are generally only reaped several years down the line (higher medium-term growth). From an electoral point of view, this is not particularly attractive. Finally, the political capital a government has to spend to adjust macroeconomic policy is far less than what it needs to spend to get structural reforms approved by congress due to its greater degree of control over macroeconomic policy instruments.

Critics will argue that the Lula administration simply got lucky, benefitting from a very favourable global backdrop. But this is a little ungenerous. Lula I/ II did raise and maintain large primary surpluses even at a time (after 2004-05) when lower surpluses would not have undermined debt sustainability. The administration also upheld the de facto autonomy of the central bank against at times harsh criticism of its tight monetary policy. The political calculus underpinning these decisions was straightforward and did pay off, leading Lula to be re-elected in 2006. The president’s approval ratings have surged since the onset of the crisis and were the president allowed to run for a third term, he would probably win hands-down.

The Lula administration’s key strategic insight was that lowering inflation and increasing economic stability, albeit at the expense of lower short-term economic growth, can be politically and electorally rewarding, as it raises the real incomes of the poor and satisfies the demands of the urban middle class for an end to near-permanent economic instability. What in 2003 may have looked like an emergency response to contain the financial crisis and avert a sovereign default has not only transmuted into a long-term policy; it has actually become the cornerstone of Brazilian economic policy and the main reason why Brazil is weathering the global crisis relatively unscathed. Is there any reason why this formula could not become a winning formula for political leaders in the currently poorly managed Latin American countries?

Responding to the crisis: Did Brazil and China miss an opportunity? (2009)

The major emerging markets have made use of their increased policy autonomy and implemented expansionary macroeconomic policies. Not only have they been able to support economic growth by letting automatic stabilizers absorb part of the growth shock. They have also managed to stimulate domestic demand through a mix of expansionary monetary, credit and fiscal measures. In fact, the IMF estimates that measured as a share of GDP the emerging G-20 countries introduced a larger discretionary fiscal stimulus than the advanced G-20 members.

Brazil and China make for an interesting comparison n in this respect. The authorities in both countries eased monetary policy and pushed bank lending to the private sector. But while both countries introduced expansionary fiscal measures, the nature of these measures differs sharply. The Chinese measures focus on raising public investment in infrastructure, while the Brazilian measures are more heavily focused on encouraging consumption. The Chinese measures tend to be temporary in nature, while some of the Brazilian measures may turn out to be more permanent. From a short-term crisis-management point of view, the measures seem to be working in terms of buffering the downturn and contributing to a speedy economic recovery. However, from a medium-term economic perspective, Brazil should have adopted the measures China has adopted – and vice versa. Brazil should have increased public investment, while China should have boosted domestic consumption.

China “suffers” from an excess savings ratio amounting to more than 50% of GDP. With investment running at more than 40% of GDP, this resulted in mind-boggling current account surpluses of 10-11% of GDP in 2007-08. Such large external surpluses are unprecedented for a country of China’s size. They are politically unsustainable and, from a welfare point of view, they are not in the interest of a relatively poor country like China. Why forego domestic consumption and finance consumption in wealthier countries in return for financial assets of potentially uncertain future value? As far as fiscal policy is concerned, China has two options to address this issue: it can raise domestic investment or it can reduce savings (raise consumption).

While some would argue that raising public investment further will lead to an inefficient allocation of capital, overcapacity and maybe even an investment bust, others would point out that, although Chinese investment is already massive, there still exist sufficiently profitable investment opportunities (esp. infrastructure in the less developed interior). However, the drawback of increased public investment spending is that it will absorb “excess” savings only temporarily. Furthermore, raising public investment by several percentage of GDP may be fraught with risks (e.g. quality of investment). A permanent increase in public or private consumption, on the other hand, would appear desirable in terms of rebalancing the economy from a potentially wasteful investment-intensive growth pattern to a more stable consumption-led pattern.

Low public debt, a modest fiscal deficit, large public savings and strong medium-term growth provide the Chinese authorities with considerable scope to finance measures aimed at raising domestic consumption. This is much less the case for Brazil, where a more onerous debt burden, substantial long-term expenditure commitments and a much lower growth rate limit the scope for permanent consumption-increasing fiscal measures. This difference also explains why China’s discretionary measures will amount to a massive 5.8% of GDP versus a mere 1.2% of GDP in Brazil during 2009-10, according to the IMF. The Chinese government can afford to boost consumption by permanently expanding, for example, health, pension and education outlays. This would help reduce public-sector savings and it might help reduce precautionary household savings, raising both private and public consumption.

The government can also address the “excess” savings of the corporate sector by taxing it more heavily. This would both reduce savings in the corporate sector and allow the government to finance further consumption measures. China thus missed an opportunity to shift towards a more balanced growth mix. That being said, if one believes that China’s capital stock remains relatively small, that there exists a sufficient number of profitable investment opportunities and that the government is competent enough to identify and implement these projects, an increase in infrastructure investment does not look like such a bad idea. Nonetheless, the fact remains that over the longer run the present investment-led growth pattern is unsustainable, economically and politically. While China may save too much, Brazil saves too little. China may or may not invest too much, but Brazil certainly invests too little. Over the past decade and a half, Brazilian domestic investment averaged a mere 17.5% of GDP, compared with China’s 40%. Savings were even lower, averaging less than 16% of GDP, compared with China’s 44%.

This largely explains why China grew at an average rate of 10% per year, while Brazil grew at a mere 3.3%. Brazil’s fiscal stimulus should therefore have focused on raising investment, not consumption. The level of (government) consumption is already high and is one of the main causes of high interest rates and low domestic investment. Brazil’s public debt position is also much less sound than China’s, making (temporary) investment measures preferable to potentially more permanent consumption measures. To be sure, not all the fiscal stimulus consists of consumption-based measures, let alone permanent ones. However, further consumption-supporting measures, including minimum wage adjustments, will be introduced later this year, and let’s not forget that 2010 is an election year! Over the longer term, Brazil will have to raise its savings and investment ratios if growth is to meet the government’s informal growth target of 5%.

So why did Brazil and China do the opposite of what would have been preferable from a medium-term perspective? Here are some hypotheses. Brazil faces greater bureaucratic obstacles to boosting public investment, so boosting consumption is a more effective way to support domestic demand in the short term. By contrast, China faces much fewer bureaucratic obstacles and has greater experience with public investment projects, so increasing public investment (by mainly front-loading or bringing forward projects already in the pipeline) seems a more optimal policy choice. Brazilian households also have a greater propensity to consume than Chinese households, so revenue measures targeting private consumption are likely to be more effective in Brazil than in China. But be that as it may ….. from a longer-term perspective both Brazil and China missed an opportunity to shift towards a more sustainable and more balanced growth mix, consisting of greater investment in Brazil and greater consumption in China.

Emerging markets and domestic-demand-led growth (2009)

Economic growth in the developed economies will likely be anemic for several years to come due to continued de-leveraging in the household and banking sector. By contrast, the downturn in the emerging markets (EMs) will be short-lived by comparison, and a rapid return to sustained growth in many, if not all, EMs is likely by 2011. Thanks to solid economic fundamentals, the EM-6 (Brazil, China, India, Korea, Mexico, Russia) have been (or will be) able to engineer a more or less rapid recovery by boosting domestic demand. However, due to permanently weaker global demand and hence weaker export growth, EMs will not match the above-average growth rates seen over the past few years.

Economic growth in the developed economies will likely be anemic for several years to come due to continued de-leveraging in the household and banking sector. The scope for policy mistakes is considerable as well. The policy stimulus may be withdrawn too early or too late: too early as a consequence of “free-riders” who exit expansionary policies ahead of time, or too late because governments find it politically difficult to implement adjustment policies. Policy-makers may also fail to put the banking sector on a footing that is solid enough to allow it to support a sustained economic recovery.

By contrast, the downturn in the emerging markets (EMs) will be short-lived by comparison, and a rapid return to sustained growth in many, if not all, EMs is likely by 2011. Due to weaker global demand and hence weaker export growth, EMs will not match the above-average growth rates seen over the past few years. But thanks to solid economic fundamentals, the EM-6 (Brazil, China, India, Korea, Mexico, Russia) have been (or will be) able to engineer a more or less rapid recovery by boosting domestic demand. While their ability to do so varies, all EM-6 countries retain scope to support domestic demand growth. This situation differs sharply from the past, when most EMs would have been forced into a pro-cyclical policy adjustment – just like several countries in Central and Eastern Europe (and even some in Western Europe!) are at the moment. 

First, the scope for stimulating domestic demand through an expansionary monetary policy remains important, with the possible exception of Korea, where central bank rates have already fallen to 2%. A limited (or non-existent) dependence on foreign capital flows, a continued large interest rate differential vis-à-vis the developed markets and a large output gap combine to limit the risk of significant currency depreciation and inflation. The EM-6 banking sectors remain, for the most part, sufficiently well capitalised to support an increase in credit growth. Lower interest rates therefore by and large remain an effective tool to support domestic credit growth and investment.

Second, the EM-6 are also in a position to pursue counter-cyclical fiscal policies, even if the room for policy discretion varies considerably. Public-sector solvency and potential financing constraints determine the degree to which governments can support domestic demand. However, even countries with large public debt burdens and non-negligible financing constraints (due to shallow domestic capital markets) retain some leeway to implement discretionary fiscal measures, in addition to simply allowing automatic stabilisers to absorb part of the growth shock. The countries with the lowest public-debt level and/or the largest fiscal reserves (China, Korea, Russia) have scope for further support measures, if necessary.

Third, in contrast to the situation in the past, the EM-6 external position is sufficiently solid to permit an acceleration of domestic demand without jeopardizing external sustainability. External liquidity and solvency indicators are relatively strong across the board. But again, the countries with the strongest external fundamentals (China, Korea, Russia) have far greater scope to increase domestic demand than the others. 

Strong fundamentals place China and Korea in a good position to boost domestic demand. Whether one should add Russia and Mexico to this group depends on one’s view of medium-term oil prices. In the short term, Russia is clearly in a better position than Mexico thanks to its large fiscal reserves. By comparison, Brazil and India are more constrained on account of their relatively high public-sector debt. (But Brazil retains considerable scope to lower interest rates, if necessary.) On the flip side, a relatively closed economy like Brazil’s gets “more bang for its buck” for the same amount of stimulus than a relatively open economy like Korea, as part of the demand stimulus will “leak” into higher imports. It is therefore just as well that the more open EM-6 economies benefit from greater fiscal macroeconomic flexibility than the less open ones!

The crisis hit the EM-6 with varying degrees of intensity via the trade channel, but also via the capital-account and the confidence channel. It is noteworthy that all EM-6 have been able– if to varying degrees – to pursue counter-cyclical, domestic-demand-oriented policies in response to the global shock. However, none of the EM-6 will be able to fully offset what is likely to be a permanent decline in external demand growth. Therefore, even if global financial conditions return to pre-crisis levels (and this is a big “if”), EM-6 economic growth will remain below its pre-crisis levels. Last but not least, it is worth pointing out that, however desirable a shift to more domestic-demand-led growth in the EM-6 is, it certainly will not pull the world economy out of the doldrums. However fast demand in the EM-6 grows, it will remain small in comparison to G-7 demand for the foreseeable future and will therefore have only a limited effect on G-7 net exports and economic growth.

Emerging markets and FX reserve accumulation (2009)

The risk of an emerging markets (EMs) crisis has been receding, even in Eastern Europe, if market risk indicators are to be believed. Risk appetite has been gradually returning and there are tentative signs that capital flows to Ems may have bottomed out. The provision of large official financing packages, combined with a sense that the risk of a financial sector meltdown in the developed markets has faded, has helped lift demand for riskier assets, including EM assets. We have not yet experienced the full fall-out from the real economy “crash”, but an economic downturn – even one as severe as this – should be more manageable than a global financial sector meltdown. The EM asset price rally has also been fuelled by the expectation that in many (but not all!) EMs the economic downturn will be sharp but short-lived, in contrast to the developed markets, where a sustained rebound will remain elusive.

The Volcker shock of the late 1970s drove many major EMs into default. Although the world economy quickly recovered from the shock, for many EMs the 1980s turned out to be a “lost decade” characterised by economic stagnation and repeated crises. This time, no major EM has defaulted and most major EMs have managed to maintain relatively sound fundamentals, measured in terms of external liquidity, public-sector solvency and banking-sector stability. Many EM economies – especially outside Central and Eastern Europe (CEE) – should therefore recover relatively quickly, even if a return to pre-crisis, US-consumer-fuelled growth rates is unlikely as long as the developed markets continue to de-leverage.

It is remarkable, though not really surprising, how resilient the EMs have proven in the face of the most severe global financial and economic crisis since the Great Depression. Key pre-crisis credit metrics predicted fairly accurately which countries were going to encounter significant difficulties and which countries would manage to “weather the storm” more easily. Countries with large liquid external liabilities relative to liquid external assets, especially if characterised by large non-FDI-financed current account deficits, proved vulnerable and many of them were forced to turn to the IMF. The majority of countries that received official bail-outs are located in CEE. This is not surprising. Many EMs in Asia and Latin America had switched – more or less deliberately and with varying degrees of intensity – to a policy geared towards FX reserve accumulation following severe capital account crises in the 1990s and early 2000s. By contrast, many EMs in CEE failed to build up a comparable external buffer.

The lesson policy-makers are likely to draw from the crisis is that the marginal benefits of reserve accumulation (economic and financial stability) continue to outweigh its potential costs (foregone economic growth, fiscal costs). Even countries with what looked like solid external positions by pre-crisis standards experienced quite disruptive capital account shocks. The shock could have been buffered somewhat more, had governments benefitted from greater policy flexibility on account of larger FX reserve holdings. At the very least, this is the conclusion many EM policy-makers will come to. The narrowing of the US current account deficit will make competition for FX reserves more intense, and this will tempt many EMs to keep their exchange rate undervalued, or at least to keep their currency from appreciating (substantially) once their balance of payments moves into surplus. A large output gap will sharply limit inflationary pressures, further enhancing the attractiveness of such a strategy. Neither the prospect of EMU membership in CEE nor the IMF’s Flexible Credit Line, only readily accessible for “well-managed” countries, will dissuade the majority of EMs from going down this path.

Equally important, many of the countries that had accumulated large FX holdings prior to the crisis will maintain policies geared towards reserve accumulation, whether or not this is desirable from a domestic growth and global adjustment point of view. Politically, it will be difficult to fundamentally change a policy that has “worked” in terms of maintaining stability. Some change at the margin is possible, but a fundamental policy change is unlikely.

Opposition to EM FX accumulation should be limited in the near term; even with respect to China, which will continue to account for the bulk of global reserve accumulation. A combination of narrowing US current account deficit, widening US fiscal deficit and increasing US reliance on Chinese purchases of US government debt seems to have led Washington to adopt a softer stance on China’s exchange rate and FX accumulation policies. The policy debate seems to be shifting from FX intervention policies and global imbalances to fiscal policy and economic growth. This should make it easier for both sides to find common ground. It also means that Beijing – and other EM countries – is likely to encounter much less resistance than pre-crisis to an exchange rate policy that is, intentionally or unintentionally, geared towards reserve accumulation.

Rise of the BRICs revisited (2009)

The “rise of the BRICs” thesis has received much criticism – some of it deserved, some of it undeserved. There is little doubt that major change is afoot, but the thesis is somewhat misleading, even deceiving, as it discounts what will be the most momentous development of the first half of the 21st century: the rise of China. Naturally, the growing economic importance of India, Brazil and Russia will have important consequences, but these simply don’t compare to the implications of China’s rise. Economically, financially and politically, China overshadows and will continue to overshadow the other BRICs. China’s economy is larger than that of the three other BRICs combined. Both China’s exports and its official FX reserve holdings are more than twice as large as those of the other BRICs combined.

China is the real story here! In Washington DC, for example, there is much talk these days about Chinese exchange rate policy and China’s rapidly increasing financial prowess, about increasing Chinese military and especially naval capabilities, even about Chinese soft power. Prominent analysts and former government officials, like Bergsten and Brzezinski, are calling for the establishment of a G-2 consisting of the United States and China. While the proposal has thus far received at best a cautious response in both Beijing and Washington and a generally skeptical response from analysts, it is a reflection of the importance Washington insiders attach to China’s growing stature. One may legitimately disagree with the G-2 proposal, but China’s increasing economic and political weight in world affairs is a reality.

China’s relative and absolute economic importance will continue to rise for the foreseeable future. In terms of economic growth, China has been outperforming the other BRICs by a wide margin over the past thirty years. Over the past decade, real GDP growth averaged 10% in China, 7% in both India and Russia and 3.3% in Brazil; and China will continue to grow faster than its peers. A high savings rate, a low level of urbanisation, low per capita income (considerable “catch-up” potential) and, importantly, a successful export-oriented, manufacturing-based development strategy underpinned by strong investment in infrastructure and education will combine to sustain China’s superior economic performance. China will also soon become the world’s largest economy (by 2025-30).

Albert Keidel (until recently at the Carnegie Endowment for International Peace) even projects the Chinese economy to be twice the size of the US economy by the middle of this century! China will be facing challenges, ranging from gradually deteriorating demographics and questions about environmental sustainability up to potential international trade frictions. Sooner or later economic growth is set to slow down from current levels. But the short and medium-term outlook remains favourable relative to the other BRICs and, of course, even more so relative to the advanced economies. Investment ratios in Brazil remain very low. Russia is overly dependent on hydrocarbons and is facing very adverse demographic developments. India will have to overcome domestic opposition to growth-enhancing and growth-sustaining economic reforms and it is not clear yet that the leap-frogging “services revolution” will turn out to be an economically and politically viable development model. For all these reasons, China will continue to outperform the other BRICs over the next couple of decades.

Economic and increasing financial openness will create stronger incentives for Beijing to make its voice heard in global economic and financial affairs, while its rapidly increasing economic and financial weight will ensure that its voice will be heard. In terms of trade openness, China is the most highly integrated economy among the BRICs. Chinese merchandise trade (export and imports of merchandise) amounts to 2/3 of its GDP compared with 1/2 in Russia, 1/3 in India and a mere 1/5 in Brazil. Moreover, Chinese growth has also become more dependent on exports (though the degree of this dependence is being hotly debated) and it is becoming ever more dependent on commodity imports, ranging from energy and metals to foodstuffs.

China may seem financially less integrated than Brazil or Russia on account of existing capital account restrictions. China remains relatively closed as far as foreign portfolio investment is concerned (even if gradual liberalisation has been taking place). However, China has been receiving large FDI inflows over the past decade (by far the largest among the emerging markets) and China’s external assets amounted to a substantial USD 2.3 tr in 2007 (and have grown rapidly since). The Chinese government has become the single largest holder of official FX reserves and of US government debt securities. With every year that goes by, China’s economic, political and financial weight will increase – and incentives to make its voice heard in global economic and financial affairs will become concomitantly and inexorably stronger. Recent official Chinese comments on US financial policy and the reserve status of the dollar already point to greater assertiveness than in the past.

None of this is meant to suggest that the “rise of the BRICs” is not a significant development. It is, but it pales by comparison with the rise of China. China is the 800-pound “panda” in the room. China will become the world’s largest economy, and a high degree of economic integration will force Beijing to become more involved in managing global economic and financial affairs. The G-2 proposal overestimates Beijing’s and Washington’s ability to jointly manage world affairs by discounting the growing importance of the other BRICs and the continued relevance of the EU and Japan. However, at the very least, the proposal is an implicit, even explicit recognition that China’s rise is significantly more important than the rise of the other BRICs and that the world must try to find a way to accommodate China’s growing importance by offering it “co-equal stakeholdership”.

Increase in IMF resources will significantly reduce risk of systemic emerging markets crisis (2009)

The recent increase in IMF resources has facilitated the reform of the Fund’s lending policies and has led to the introduction of a new Flexible Credit Line. The FCL will provide “well-managed” emerging markets with very substantial ex-ante, upfront financing. Less “well-managed” emerging markets will continue to have access to traditional Stand-by Arrangements. The increase in IMF resources should sharply reduce any concerns about the Fund’s ability to “bail out” the emerging markets.

The commitments made by the G20 just over one month ago in terms of additional funding for the IMF and the MDBs have sharply reduced the risk of a systemic emerging markets (EM) crisis. The Fund will see its loanable resources double, rising from USD 250 bn to USD 500 bn. This amount is to be raised to USD 750 bn over time. In addition, the Fund plans to issue USD 250 bn worth of SDRs to increase global reserve assets. 

The summit also pledged funds to increase MDB lending and put in place a trade financing facility for EMs. Combined with the recent reform of IMF lending policies, this has helped improve investor sentiment towards EMs. The new IMF lending facility, the Flexible Credit Line or FCL, offers borrowers very attractive terms (e.g. large up-front borrowing, only ex-ante conditionality, relatively attractive financial terms). Ex-ante conditionality means that only “well-managed” countries will have access to it. The FCL is meant to signal to investors that well-managed EMs have almost unlimited access to official liquidity. This should alleviate investor concerns about an EM liquidity crisis, lead to a renewed focus on counterparty credit risk and hence a greater willingness to extend credit to EMs. So far, Mexico has signed up to a FCL and Colombia and Poland are in the process of doing so. Other well-managed EMs may request credit lines in the coming weeks and months.

Unlike during previous “sudden stop” episodes, most EM sovereigns continue to have access to international capital markets. This time, the problem lies with an EM private sector encountering difficulties to roll over its external obligations with G10 banks (and other lenders). Countries with sufficient FX reserves like Brazil were able to deal with this situation by putting in place large FX reserve backed-financing lines to support the private sector. Countries with lower FX reserves, understandably keener to preserve their less ample assets, have not been able (or willing) to act as preemptively as Brazil. The additional financial cushion provided by the FCL will make it much easier for key EMs to support their foreign exchange-strapped private sector.

Even if you believe that the financing problem is due to the supply side (capital-constrained G10 banks) rather than the demand side (excessive EM risk), the new IMF facility will improve the outlook for capital flows to EMs by improving the risk-reward trade-off for investors, at least as far as well-managed EMs are concerned. Traditional, politically less attractive Stand-by Arrangements (SBA) will remain an option for less well-managed EMs (read: countries in need of adjustment). Here also, the substantial increase in IMF funding should reduce whatever concerns there may have lingered about the ability of the Fund to support EMs.

While previous “emergency” facilities were never taken up (e.g. CCL, SLF), probably due to the stigma attached to them and lower access limits than under the FCL, the FCL is likely to be popular, and demand for IMF funding may therefore increase significantly. Outstanding loan commitments (including Colombia and Poland) currently amount to USD 145 bn versus USD 500 bn in loanable funds. Turkey and several smaller Eastern European countries will sign SBAs soon. Add a couple of mid-sized SBAs from other parts of the world and a few more FCLs and IMF loan commitments could quickly exceed the pre-G20 summit level of loanable resources of USD 250 bn. But as the larger EMs (China, India, Brazil, Russia) are unlikely to request FCLs, total IMF loan commitments are not likely to exceed USD 400 bn anytime soon.

Nonetheless, following the reform of lending policies, the Fund would be well advised to ensure that the G20 make good on their commitments. For now, the USD 500 bn in loanable resources should be enough to “bail out” the emerging markets – assuming, that is, that no developed market will require IMF financial support. The lending reform and increased Fund resources should sharply reduce concerns about a general financial meltdown in the EMs – concerns that were probably overstated in the first place. Investor sentiment towards Ems may remain volatile, moving in large measure in tandem with changing financial market conditions in the developed markets. Nonetheless, the G20 agreement has put a firm cap on EM risk.

Brazil - Emerging stronger from the global financial crisis (2009)

The global economic crisis may cause a decline in Brazilian economic growth this year, but it won’t cause a financial crisis. Brazil is well positioned for a rebound once the world economy stabilises. Thanks to sizeable FX reserves, a solid public-sector debt position and a fundamentally sound banking system, its short and medium-term growth outlook has improved relative to many other emerging and developed markets. Brazil will emerge relatively stronger from the global economic crisis.

The world economy is experiencing the worst downturn since World War II and the worst banking crisis since the Great Depression. Brazil won’t be able to escape the economic slump, but various factors suggest it will emerge stronger from the crisis compared to many other emerging and developed markets, many of which will be struggling with substantial debt burdens and debilitated banking systems.

First, net external financing needs are small. The current account should be largely financed by net FDI inflows this year, limiting Brazil’s dependence on net debt inflows at a moment when global financial flows are falling sharply. A low dependence on net non-FDI flows makes Brazil less vulnerable than many other emerging markets. The depreciation of the real exchange rate in Q4 2008 has helped to absorb the shock to the current account. The sharp slowdown in domestic demand and declining profit remittances on the back of lower corporate profitability and a weaker exchange rate will also help limit the current account shortfall.

Second, gross external financing requirements are also manageable even if external roll-over rates remain at low levels. The central bank has built up large FX reserves which shield the economy against the capital account shock. The central bank has announced a programme to provide short-term financing to the corporate sector and its balance sheet looks strong enough to extend these lines into 2010, if necessary. Thanks to large FX reserves and a floating exchange rate, Brazil is well positioned to ride out the external liquidity crunch.

Third, the government’s external debt position is solid. Today, the public sector is a net foreign currency creditor. This means that net public-sector debt declines if the currency weakens. In the past, a high degree of FX-denominated or FX-linked government debt and lower levels of FX reserves represented a major vulnerability, since exchange rate shocks increased government debt and quickly raised concerns about public sector solvency. Today the situation is the reverse, even after accounting for central bank FX transactions (e.g. provision of short-term credit to the private sector).

Fourth, fiscal policy and public-sector solvency are not near-term concerns. While increasing risk aversion and interest rates forced Brazil in the past into a pro-cyclical fiscal adjustment, this time the government can afford to let automatic stabilisers absorb the economic downturn. Whether Brazil can afford to run a fully-fledged countercyclical fiscal policy is more debatable given relatively high public debt. In practice, it probably does have some limited room to introduce a fiscal stimulus due to the fact that the government entered the economic downturn with a 4% of GDP primary surplus. Realistically and sensibly, the primary surplus will fall to somewhere between 2% and 3% of GDP. It is worthwhile noting that a 2-2.5% surplus will be sufficient to stabilise the net debt ratio at its current level.

Last but not least, Brazil has substantial scope to ease monetary policy. Unlike in the past, Brazil is in a position to substantially lower interest rates and stimulate domestic demand without jeopardising economic stability. The collapse in domestic demand and a benign short-term inflation outlook will provide the central bank with plenty of scope to cut interest rates. Unlike in other economies where central bank policy rates are falling (or have already reached zero), Brazilian interest rates have a long way to go before they reach zero. Lower interest rates combined with a fundamentally sound, well-capitalised and liquid banking system will sooner or later “unclog” the credit channel and re-ignite domestic demand. Brazil is not going to fall into a “liquidity trap”.

Brazil won’t escape the economic slump, but it is well positioned for a sustainable rebound once the world economy stabilises. The factors that will constrain economic growth in quite a few developed and emerging markets over the next several years do not apply (or apply less) in Brazil. Solid credit fundamentals, a sound banking system, a manageable public debt burden and a continued commitment to fiscal discipline will help ensure the resumption of sustainable long-term growth. Brazil won’t be expanding at 6% levels, of course, but the medium-term outlook relative to many other emerging and developed markets has improved. Brazil is indeed set to emerge stronger from the global financial crisis.

BRIC outward FDI - the dragon will outpace the jaguar, the tiger and the bear (2009)

Economic and financial commentary generally focuses on BRIC FX reserve accumulation. BRIC outward foreign direct investment typically attracts less attention. While BRIC FDI remains relatively small, their FDI potential is substantial. On account of its economic size, rapid economic growth, large external surpluses and the nature of political-strategic incentives, China has by far the largest outward FDI potential. It will be interesting to observe whether the current crisis will lead China to move closer to realizing its considerable potential.

The BRICs are becoming increasingly important economic players. In 2007 the BRIC countries’ share of global GDP amounted to almost 13% (measured at market exchange rates) or to 20% (in PPP terms). The BRICs are also becoming increasingly important financial players. BRIC external assets amounted to more than USD 4.1 tr in 2007, a 45% increase from the previous year! Although combined BRIC external assets remain much smaller than the United States’ estimated USD 17 tr, the medium-term outlook for external growth remains favourable, current volatility in global financial flows notwithstanding.

BRIC FX reserve accumulation generally receives more commentary than BRIC outward FDI, politically sensitive investment projects excepted. This is not surprising. In spite of considerable external asset growth, BRIC outward FDI flows and stocks remain relatively small. In 2007, the BRIC share of the global FDI stock was a mere 3.3% (USD 510 bn), while flows amounted to a somewhat higher 4.5% (USD 90 bn), much smaller than the BRIC countries’ economic weight. To put these numbers into perspective, combined BRIC outward FDI flows were smaller than Italy’s. The BRIC share in global flows has, however, increased substantially from 1% in the 1990s to 4% during 2003-07. Although China’s outward FDI remains smaller than Russia’s, there are good reasons to believe that it will increase more quickly and substantially in the coming years.

First and most trivially, China’s greater economic size, its faster economic growth rate and, especially, its larger external surpluses are likely to support significant external asset accumulation. On the current account side, China will run much, much larger surpluses than the other BRICs (which won’t run any surpluses at all over the next few years). On the capital account side, China will receive larger equity inflows (incl. FDI) and benefit from sizeable debt inflows, generating persistent capital account surpluses over the medium term (partly thanks to tighter restrictions on capital outflows). A share of this surplus will be recycled in the form of FDI.

Second, China’s “catch up” potential is significant. Its outward FDI stock and flows are low as a share of GDP and as a share of total external assets. The FDI stock amounts to a mere 3% of GDP, compared to Brazil’s 10% and Russia’s 20%. External asset holdings are also heavily skewed towards reserve assets, and in dollar terms Chinese FDI is smaller than Brazilian and Russian FDI! The lower level of FDI is in part due to the rapid increase in the size of the denominator (GDP measured in USD, external assets) and in part due to (historically) significant restrictions on outward FDI. Rapidly rising per capita income over the coming years should therefore support rising Chinese outward FDI. Admittedly, all these metrics are very rough but they do give an indication of China’s catch-up potential.

Third, the government has liberalized regulations governing outward FDI flows in recent years and has streamlined bureaucratic procedures. The government offers various kinds of support for Chinese companies seeking to invest overseas as part and parcel of its “going abroad” and “national champion” policy. Today the FDI regime is much more supportive of (or at least far less restrictive towards) outward FDI than in the 1990s and this should help lead to increased outward FDI flows. 

Last but not least, wider strategic objectives should support Chinese FDI outflows. As a consequence of very resource-intensive economic growth, China’s commodity dependence has increased significantly in the past few years. The government will likely be very supportive of Chinese companies that seek to acquire natural resource assets in particular by limiting commercial risk and providing financial incentives to Chinese companies to “go abroad”. True, governments in Brasilia, Delhi and Moscow also face strategic incentives to support outward FDI, but their commodity dependence is (much) less pronounced.

China has by far the greatest FDI potential among the BRICs on account of economic size, rapid economic growth, large external surpluses and the nature of political-strategic incentives. Assuming (and this is just an assumption) that Chinese companies face the same intensity of microeconomic incentives (e.g. market-,efficiency, asset-seeking) as companies in the other BRICs, Chinese FDI could outstrip the combined outward FDI of all other BRICs already a few years from now. China certainly has the potential to become one of the top global foreign direct investors over the course of the next decade. It will be fascinating to see how Chinese companies will respond to the recent cheapening of company valuations in developed and emerging markets, and to the slowing economic growth in their home market.

Source: UNCTAD

Emerging markets were going to weather the storm … but will they survive the hurricane? (2009)

The global economy is experiencing the most severe downturn since World War II. The severity of the economic and financial crisis has exposed vulnerabilities in a number of smaller emerging markets, forcing them to request IMF support. Thanks to solid fundamentals, the larger, systemically important emerging markets should be able to avoid a 1990s-style balance-of-payments-cum-sovereign crisis this time. All of them, without exception, will, however, experience a sharp slowdown in economic growth.

The financial breakdown and sharp economic contraction in the advanced economies have spilled over into the emerging markets (EM), leaving in their wake declining FX reserves, battered financial systems and a pronounced weakening of real economic activity. Sharply slowing exports, plummeting commodity prices and sizeable capital outflows have hit EM financial markets. The global financial dislocation has also exposed financial vulnerabilities in a number of smaller EMs, forcing several of them to request IMF financial support.

At the beginning of last year, we suggested that the systemically important EMs (China, Brazil, India, Russia, Mexico, Korea, in short: EM-6) would weather the proverbial storm thanks to their solid external solvency and liquidity positions. This prediction was based on a scenario where the world economy would be undergoing a cyclical economic downturn, some downward adjustment in commodity prices and lower capital flows.

Unfortunately, the expected storm has since turned into a category 5 hurricane. The global economy is faced with the most synchronized, most severe and probably most protracted economic downturn of the post-WWII era as well as the most severe banking sector crisis since the Great Depression. Has this changed our view?

As Keynes quipped, “When the facts change, I change my mind”. Well, the facts have certainly changed, but we are not quite ready to change our mind yet. At the beginning of the crisis, the EM-6 had enough official FX reserves to cover their 12-month external financing requirements. This is generally regarded as a comfortable position. However, this metric does not capture all potential sources of balance-of-payments pressure. It does not include equity liabilities, nor does it take into account off-balance sheet liabilities related to cross-border derivatives transactions. Nor does it capture resident capital flight. Nonetheless, the comfortable external financing positions theoretically mean that as long as the authorities refrain from “financing” these types of outflows by drawing down their FX reserves, the countries will have sufficient funds to stay current on their debts falling due over the next 12 months, albeit at the risk of substantial currency depreciation in the event of, for example, substantial resident capital flight.

Two important sources of balance-of-payments pressure have weakened since the onset of the crisis. The value of foreign portfolio holdings in the EM-6 has declined substantially on the back of large Q4-2008 outflows, dramatic equity market correction and/or significant currency depreciation; and losses related to off-balance sheet transactions seem to have been largely realized. EM-6 FX liquidity has stagnated or declined in recent months, only Mexico’s 12-month financing requirements now exceed its FX reserves (but only very slightly). Resident capital outflows in the EM-6 should remain manageable as the risk of a sovereign default or a systemic banking crisis is low – and as long as the authorities devalue the exchange rate and allow domestic interest rates to rise. This also applies to Russia, where FX reserves have fallen most, the current account is being hit the hardest and which has seen the largest resident capital outflows.

In a typical crisis, capital inflows recover after a while, allowing EMs to avoid drawing down all their external assets. But what if this time is different and the EM-6 only have very limited access to external capital markets over the next 12-24 months? What if capital-constrained financial institutions and spooked investors in the advanced economies remain reluctant to lend to EMs? What if banks that have tapped government bail-out programmes encounter significant political opposition to extending funding to EMs? What if the huge amount of expected fiscal-stimulus and bail-out related sovereign and sovereign-guaranteed debt issuance in the developed markets leads to a diversion of funds away from EMs? In this case, some combination of sizeable FX reserve buffers, bilateral swap agreements and access to the IMF’s short-term liquidity facility should provide the EM-6 with enough time to adjust their current account positions by way of a further (substantial) currency devaluation and a further (sharp) slowdown in economic growth.

We therefore continue to believe that the EM-6 will survive the hurricane and will avoid shipwreck (i.e. the kinds of sovereign or balance-of-payments crises we saw in 1995, 1997, 1998 and 2001). This should hold true, even if the global financial crisis lasts longer than currently expected. The EM-6 economies are being battered and are already seeing a sharp deceleration in economic growth. The economic slowdown could become even more pronounced, should they remain shut out of international capital markets for longer than expected and be forced to adjust their balance-of-payments more drastically on the current account side. The recent Brazilian and Mexican sovereign bond issues have raised some hope that this can be avoided. However, under either scenario a systemic financial breakdown looks unlikely. But remember: if the facts change, we may have yet to change our mind.