In the event of another global shock, the emerging markets (EM) remain well-positioned to cope with its economic and financial consequences. Inevitably, a sharp slowdown in global economic growth, let alone a recession, will negatively impact EM growth. Most EM weathered the 2008 financial shock without succumbing to systemic financial instability (aka sovereign and/ or banking sector crisis). Some of the larger EM received IMF support with no conditionality attached (Colombia, Poland and Mexico). The bulk of EM was nonetheless able to absorb the shock without suffering lasting structural damage. True, bank lending increased substantially in the wake of the crisis in some countries, raising risks. But fair medium-term growth prospects provide sufficient room to work off potentially rising credit risks over time. Last but not least, EM governments benefitting favourable debt dynamics would be in a position to support local banking systems should this become necessary.
The external liquidity position of the major EM remains solid, generally speaking. Under conditions of a pure float (and manageable FX mismatches in the public and banking sectors), the level of required FX reserves is close to zero. The more rigid the exchange rate arrangement (excluding currency unions), the more FX reserves will need to be held. The experience of the past two decades has shown that more often than not the breaking of a currency peg under market pressure triggers severe government debt and banking crises. Hence the required level of pre-cautionary is substantially higher under more rigid regimes (more prevalent in the past) than under more flexible arrangements. It is no surprise therefore that EM with more rigid regimes have larger FX reserves (e.g. China, Saudi Arabia). Similarly, EM with more (e.g. Brazil, Indonesia, Poland, South Africa and Turkey) or less flexible regimes (e.g. Russia) tend to have relatively lower FX reserves.
There are various ways to measure liquidity risk. Under conditions of an open capital account, the so- called liquidity ratio is useful. (In case of a currency board M2, or another monetary aggregate, to FX reserve ratio and in the case of a closed capital account import cover may be better ways of capturing liquidity risk.) It captures the sensitivity/ vulnerability of an economy to a capital account shock. It is the ratio of short-term liquid assets (FX reserves and commercial banks’ liquid foreign assets) to short-term liquid liabilities (short-term debt on a residual basis and non-resident holdings of local-currency (LCY) debt of all maturities). The intuition is that if liquid assets exceed liquid liabilities, the economy is, generally speaking, in okay shape.
The liquidity ratio however overstates actual vulnerabilities, as it adds all marketable LCY debt securities held by non-residents to the denominator. Since the bulk of non-resident holdings is typically invested in maturities of more than one year, non-residents seeking to exit their holdings and exchanging the proceeds into FCY would suffer severe valuation losses such that the actual drain on FX reserves would be far less than what is implied by the liquidity ratio. This is of course more relevant under very flexible exchange rate regimes.
The liquidity ratio does not take account of current account financing needs. External financing requirements do. It captures an economy’s external debt service obligations (short-term debt on a residual basis) and current account financing requirements relative to FX reserves. Interestingly, the two liquidity risk measures tell a similar story in terms of EM external liquidity risks: Poland and Turkey appear to be the economies most vulnerable to a capital account shock among the major EM.
A few additional observations are in order, though. All major EM look well-positioned to weather an external shock and FX depreciation, as all EM governments are either net FX creditors or run basically a neutral FX position. Even a sharp currency depreciation would therefore fail to undermine government debt dynamics due to resulting balance sheet effects stemming from foreign-currency mismatches. Moreover, the economies with weaker external liquidity (e.g. Poland, Turkey) are also characterised by quite flexible currency regimes, allowing them to absorb a shock largely via the exchange rate.
Last but not least, other idiosyncratic factors, not captured by the above indicators, act as risk mitigants – leaving aside potential issues relating to data quality. External financing requirements do not take into account often tangible and almost always quite stable FDI inflow into account. A share of Polish short-term debt consists of lending from foreign parent banks to their local subsidiaries. These lines are likely to be rolled over even during a crisis and even if it is necessary to overcome some co-ordination problems on the part of the banks (e.g. Vienna initiative). In the case of Turkey, the banking system faces significant restrictions in terms of the FX exposure it is allowed to run, while its scope to extend on-shore FCY lending, a potential source of significant credit risk in the event of currency deprecation, is also limited. The capacity of both the government and the banking system to sustain a sharp depreciation allows both Poland and Turkey to survive even a severe liquidity shock.
In short, the EM are well-positioned to withstand an external shock in terms of maintaining systemic financial stability. Poland and Turkey, EM with weaker liquidity ratios, also seem reasonably well-prepared given solid government net FX debt positions, manageable FX mismatches in the banking sector and a floating currency. This is what the 2008 crisis demonstrated and this is also what external liquidity risk measures are telling us with respect to future shocks.