The emerging markets weathered the 2008-09 global financial crisis without sustaining structural damage. True, a small number of EMs received liquidity support from the IMF. But thanks to by and large sound fundamentals, the EMs adjusted to the capital (and current) account shock through a combination of FX depreciation, central bank liquidity support and domestic economic contraction. In the past few years, global financial conditions have been very supportive, as reflected in ultra-loose monetary policies in the major advanced economies and strong capital flows to the (higher-yielding) EMs. So it may be time to ask which EMs are most exposed to a sharp slowdown in capital flows.
A variety of indicators are used to gauge an economy’s sensitivity to capital account shocks. Perhaps the most commonly used one is external financing requirements (EFR). EFR are equivalent to short-term debt, medium- and long-term debt amortisations and the current account in relation to FX reserves. Admittedly, in today’s world where the capital accounts of the major EMs are relatively open and foreign investors hold in some cases significant amounts of LCY-denominated portfolio debt and equity, potential balance-of-payments pressure can far exceed EFR.
However, it is clear that non-resident LCY - and especially equity-claims will weigh far less on the balance-of-payments than short-term FCY-denominated debt claims. This is particularly true in the case of economies with floating exchange rates. Moreover, EFR do not include either non-reserve assets or foreign assets held by the private sector. In spite of these limitations, EFR provide a fair idea as to the potential vulnerability of an EM in the event of an external liquidity shock.
A rule of thumb says that an EFR ratio of less than 100% is “safe” in terms of even a severe balance-of-payments crisis. In fact the Greenspan-Guidotti rule says that FX reserves should at least be equivalent to short-term foreign debt (on a residual maturity basis). Given that EFR include current account related financing needs, EFR of less than 100% are therefore reflective of a pretty solid liquidity risk profile. Moreover, China, Korea and Russia run small current account surpluses, but short-term debt (on a residual basis) in all these countries amounts to less than 50% of FX reserves in 2013. The EFRs are especially favourable given that most of the large EMs have relatively free-floating exchange rates. China and Russia, the EMs with the least flexible currency regime, incidentally have the lowest EFR. Only Turkey is bit of an outlier. Last but not least, it is worth comparing current EFR to those observed just before the massive global shock of 2008. Korea, Poland (not even taking account IMF FCL) and South Africa have much stronger positions, while India and Indonesia have slightly weaker (but still solid) positions (< 100%). Only Turkey’s EFR are today both higher than in 2008 and above the 100% threshold.
In the past, so-called sudden stops or capital flow reversals often translated into higher government debt ratios and worsening sovereign risk. If FCY risk is concentrated in the systemically important sector government or banking sector, a capital flows shock can quickly transmute into a systemic crisis. Today, however, the consolidated public sectors in all major EMs are net FCY creditors. Many EMs have put in place regulations limiting the extent to which banks can run FCY risk, while more flexible exchange rate have removed banks’ incentives to run open FCY positions, thus limiting FCY risk in the systemically important banking sector.
To sum up, the top-10 emerging economies appear well-prepared to withstand a significant tightening of external financing conditions. External liquidity indicators are roughly comparable to those observed just before the massive 2008 global financial shock. Turkey is the EM most sensitive to tightening financial conditions on account of both its large short-term external debt and large current account deficit. Thanks to limited FCY mismatches in the government and banking sectors, an adverse external liquidity shock would translate into currency depreciation and a potentially sharp economic slowdown à la 2008-09. To what extent such a scenario would impact the corporate sector, where virtually all of the FCY risk is concentrated, and to what extent this would impact the banking sector’s financial position by way of their FCY lending to the domestic corporate sector would in part depend on how prolonged currency weakness and the economic slowdown last. Systemic risks appear nonetheless manageable for now, not least because the banking sector is well-capitalised.