The IIF forecasts
net private capital flows to emerging markets will decline dramatically from $930 billion in 2007 and $470 billion in 2008 to a paltry $170 billion in 2009. Commercial bank lending is forecast to turn negative this year. This "sudden stop" has already forced several emerging markets to request IMF programmes. In addition, exports are collapsing on the back of the global recession. The six largest emerging markets or EM-6 (Brazil, China, India, Korea, Mexico and Russia) have been hit hard. However, they are in a sufficiently strong position to fend off an external solvency and a systemic banking sector crisis (the hallmarks of most of the emerging markets crises of the past 15 years) thanks to manageable foreign currency and foreign liquidity mismatches.
Manageable foreign currency exposures
The six largest emerging economies have no or very manageable foreign currency mismatches.1 Previously, extensive foreign currency mismatches induced a "fear of floating", which was among the main causes of the financial crises in Mexico (1994/95), Korea (1997), Russia (1998), and Brazil (1998/99). Due mainly to foreign exchange reserve accumulation and domestic de-dollarisation, today the EM-6 have either no aggregate foreign-currency mismatch (China, India) or only limited ones (Brazil, Korea, Mexico and Russia).
For example, domestic fixed income markets have been almost fully de-dollarised (e.g. Brazil after 2002 crisis) and banking sector deposit dollarisation is low. In Russia, the big emerging economy with the highest degree of deposit dollarisation, total foreign-currency deposits in the banking sector as a share of foreign exchange reserves and domestic banks' foreign assets amounted to a mere 10% at the end of last year, according to Moody's. The absence of a significant aggregate foreign-currency mismatch will allow these economies to let their currencies depreciate in response to a balance-of-payments shock without undermining their economy's solvency.
External liquidity risks
External liquidity risks are manageable in all six economies due to rapid foreign exchange reserve accumulation (Figure 1). Official foreign exchange reserves more than cover 2009 external financing requirements (current account plus short-term debt plus longer-term debt amortisations). Historically, external financing requirements of less than 100% have proven comfortable in terms of preventing a liquidity crisis. Of course, this crisis is especially severe. On the other hand, external financing requirements overestimate the potential pressure on a country's external liquidity position, as this metric excludes less fickle financing flows (e.g. official funding, FDI) as well as private sector external assets. Barring concerns about an imminent sovereign default or banking sector insolvency, other potential outflows (e.g. non-resident equity and long-term fixed income security holdings, resident deposits) should be self-limiting – provided the authorities allow the currency to adjust. Last but not least, the big six benefit from bilateral central bank swap lines (Brazil, Korea and Mexico) and/or may be eligible to tap the newly created IMF short-term liquidity facility. In short, a country that can afford to let its currency depreciate without undermining its solvency and whose official foreign exchange reserves cover 12-month-forward financing requirements is very unlikely to run into serious external financing difficulties.
Figure 1. External financing requirements in 2009
Private sector vulnerabilities
Although the aggregate foreign-currency and liquidity mismatches are manageable, the private sector is clearly vulnerable to a "sudden stop". The public sector may not suffer any more from a "fear of floating", but parts of the private sector are terrified by it. This may explain why most of the six largest emerging economies have attempted – with varying degrees of intensity – to prevent an "under-shooting" of the exchange rate by intervening in the foreign exchange market. Nonetheless, sovereign balance sheets remain strong enough to support the private sector (e.g. Brazilian central bank programme to re-finance private sector debt amortisations). The ability to do so is especially critical in cases where the banking sector has incurred large amounts of short-term foreign-currency debt (Korea and, less so, Russia).
What if the credit crunch lasts for more than a year? Will foreign exchange reserves be large enough to support the private sector? A back-of-the-envelope calculation suggests that external financing requirements will remain at acceptable levels in 2010, even under conservative roll-over assumptions and current account forecasts. Naturally, where governments provide foreign-currency liquidity to the private sector, they retain the option of reducing the pressure on foreign exchange reserves by withdrawing support from private sector debtors whose potential default does not pose any systemic financial and economic risks.
Two sources of concern
Two caveats are in order.
- First, foreign exchange reserve positions could be hit by the need to bail out the banking sector.
The very severe economic downturn and, in some cases, significant sectoral foreign-currency mismatches will put sizeable downward pressure on banks' asset quality and capitalisation ratios. However, the emerging economies' governments look like they are in a position to support systemically important domestic banks (e.g. Korea's 30 trillion won re-capitalisation fund) by issuing domestic debt instead of drawing on their foreign assets (over and above what is required to cover banks' foreign-currency liabilities). This is what a cursory look at government debt levels and potential credit losses would suggest (Table 1). To make this point more persuasively, it would be necessary to estimate potential banking sector losses and re-capitalisation needs (if any) in a methodical manner, including banks' market-related losses.
Table 1. Government debt and credit
- Second, governments could draw down foreign exchange reserves for budget deficit financing purposes.
This appears especially relevant in Russia, where the government has announced its intention to draw on its two sovereign funds (whose assets are included in the foreign exchange reserves currently worth $380 billion). Barring a major change in projected balance-of-payments dynamics or fiscal policy stance, Russia's foreign exchange reserves could fall to less comfortable levels of $200 billion by end-2009 and even lower than that by end-2010. This "dual use" of foreign exchange reserves for balance-of-payments and budget financing may explain why Russian CDS spreads are substantially wider than its peers (Figure 2).
Figure 2. Sovereign CDS spreads
But the exchange rate must be allowed to adjust
Manageable foreign currency and maturity mismatches, combined with solid public sector solvency positions, sharply limit the risk of an external payments default and a systemic banking sector crisis in the six largest emerging economies. This call is premised on the assumption that policymakers will allow the exchange rate to adjust (where necessary) and refrain from running outsized fiscal deficits geared towards propping up economic growth, especially where deficits are financed by drawing down sovereign foreign exchange assets. Economic growth will be hit very hard in all six countries, but they won't suffer a systemic financial breakdown. The EM-6 will be battered, but the global crisis won't sink them.
1 Following Morris Goldstein and Philip Turner, a currency mismatch "occurs when residents of the country are not adequately hedged against a change in the exchange rate so that a large depreciation generates a large fall in the economy's net worth". A "long" foreign currency position is also technically a mismatch, but it is of less relevance from a crisis susceptibility point of view. I use "currency mismatch" as meaning "net short foreign currency".