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.