beyondbrics

By Manoj Pradhan

Emerging market economies cannot decouple. More importantly, they shouldn’t try to if they want to protect growth. Wondering whether EM economies will decouple is surely pointless when we say in the same breath that markets are rapidly becoming more internationally integrated.

What has changed, however, is the origin and nature of EM crises. Ironically, it is the very success of EM economies in attracting capital inflows and lending from global banks that exposes them to the risk of a sudden shocks should these inflows slow down dramatically, or even reverse.

Not unlike the 2008 financial crisis, the shock that could set off sudden stops in EMs now is more likely to come from outside than within. With the US economy seeing better growth than was expected, the world economy is in a better place than seemed to be the case just a few months ago.

However, despite the relief of Greece approaching an agreement with its creditors, the risk of a serious shock emanating from Europe cannot be ruled out since so many critical issues still need to be resolved.

But do we really still need to worry about EM sudden stops even today? Haven’t EM economies built up substantial FX reserves as insurance? Don’t most of them now run current account surpluses which makes them net exporters of capital? Aren’t their fundamentals better than ever? Valid points all. However, sudden stops occur when gross liabilities cannot be rolled over. Net positions and fundamentals matter but may not be enough to prevent a sharp fall. A look at the changing nature of EM crises tells us why.

Old- style EM crises – the kind that happened before the 1980s – consisted of bouts of overspending and worsening current account deficits that ultimately resulted in currency devaluations. Compared to events over the last two or three decades, such crises occurred almost in slow motion and the adjustments were small in size as well. Importantly, the origin of these crises was almost entirely domestic in nature.

The crises of the 1980s and 1990s involved public or private balance sheet issues along with sharp exchange rate movements. It didn’t matter which came first, the other always followed in tow. The Latin American debt crisis stretching from Mexico’s default in 1982 to Brazil’s 1998 episode all occurred due to the inability of servicing US dollar denominated public debt. The Asian crisis of the late 1990s was precipitated by the private sector balance sheet.

What differentiated such crises from previous ones is the speed with which capital flowed out, resulting in almost total depletion of the small amount of FX reserves and a crash in currency values. In both types of crises, the IMF played a critical role in not just providing funds but also credibility to the post-crisis macro reconstruction. The role of global factors in these episodes was likely a contributing factor but not the main one.

Since then, things have changed again. Lessons have been learnt. Current account surpluses rather than deficits are more the rule for the EM economies that we cover (though the prominent exceptions are deficits in Turkey, India, Brazil and Poland). National balance sheets are in much better shape now, with FX reserves more than enough to cover external short-term hard-currency obligations. These improvements had even the IMF wondering about its own role in the world before the Great Financial Crisis roared it back into relevance.

So why are EM economies not ‘safe’ now? The truth is that they are safer than they were, but are still not immune.

EM economies have been victims of their own success. Lending by global banks to EM economies and capital flows thanks in particular to QE have pushed capital into these economies to chase higher growth and returns. Together, the increased gross exposure and the surge of capital inflows means that EM economies remain exposed to the risk of sudden stops.

In a recent note, my Morgan Stanley colleague Patryk Drozdzik and I identified Turkey, Poland, Chile, the Czech Republic, Mexico, Hungary and Brazil as most exposed to a sudden stop (i.e., a dramatic slowdown or even outright reversal of capital inflows that they have received over the last couple of years). To see which economies are in the line of fire if capital inflows halt or reverse direction, we used four ‘triggers’:

(i) A surge of portfolio inflows from the recovery in 1Q09 until the EM slowdown started in 2Q11,

(ii) The surge in global (particularly European) bank lending to EM economies over the same time period,

(iii) A metric that measures the ‘original sin’ – the amount of short-term external debt relative to the total external debt burden as well as the amount of FX reserves held.

(iv) The joint concerns of financing a current account deficit and running credit growth in excess of nominal GDP growth.

The economies at risk do have protection. For example, Turkey has a high stock of gross assets so that its net position is far less worrisome while Chile and even Hungary run current account surpluses. Poland and Mexico have access to a flexible credit line from the IMF that it has not tapped. But these economies remain at risk. Why?

It’s the gross exposure that matters. Net positions come into play only after the initial shock. When an economy is no longer able to roll over its gross liabilities (usually private sector liabilities), it may well use its assets to pay off its obligations. Thus, we may not have defaults, but the activities that were being financed by those liabilities also have to be wound down rapidly. This implies a macroeconomic shock due to the sudden stop in funding markets.

By the time FX reserves (assets on the public sector’s balance sheet) are used to counter these problems, the damage to the currency, to domestic markets and to investor positions will already have been done. Recognising the better fundamentals and improved valuations, capital may come back to these economies but the rise will come only after the fall.

In a nutshell, EM economies have better fundamentals and better insurance against crises, but they are not immune. Surges of capital inflows into EM economies raise the risk of a sudden stop should these flows stop or reverse direction. The greater inflow of capital they have received exposes the economies we identify in our note to a higher risk of a sudden stop relative to their peers.

The shock that triggers a sudden stop is likely to come from developed markets. Critically, this means that the old weapon of past crises – improving competitiveness of exports due to a depreciation of the currency – is no longer effective. If the shock is global in nature, then world trade could shrink, meaning reliance on exports would hurt, not help. Despite their much improved dynamics, EM economies cannot decouple from their developed market counterparts. What is also a new truth, however, is that developed markets can no longer decouple from EM growth either.

Manoj Pradhan is global emerging markets economist at Morgan Stanley

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