Friday, June 26, 2009

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.