Friday, 14 February 2014

Emerging market troubles

There has been a series of posts on emerging market troubles in the past few weeks. Dani Rodrik, Nouriel Roubini, Kenneth Rogoff, Tyler Cowen and the FT's Beyondbrics have all pondered on the great issues facing the emerging markets in the past few years and months (Project Syndicate has an entire section devoted to the loss of momentum in the EMs dubbed "Subemerging Markets?"). Many of the concerns they express don't seem to be fading, in fact they are likely to become even more pronounced in the years to come. 

Arguably the main issue over the past months have been declining currencies and capital flight, mostly due to various political disruptions (Argentina, Brazil, Turkey, Ukraine, Thailand, India, etc.). In addition the tapering of Fed's quantitative easing (tighter monetary policy) is causing havoc to many countries whose currencies are tied to the dollar and whose foreign debt is dollar-denominated. 

It seems that the economic crisis in the West has after all affected the emerging markets. It was actually quite foolish to think that EMs would be intact following the decline of aggregate demand in the West. After all, Europe and America are the EM's biggest export markets. As Reinhart and Rogoff have warned us in their influential book "This Time is Different": banking crises in the West slow its economic activity thus hitting exports of EM countries, lowering the access to foreign currency the EMs need to service their debts. Weak global growth will depress commodity prices thus further reducing earnings of commodity exporters (mostly EM countries). The global credit squeeze makes in even harder for the EMs to raise new debt and fund their activities, while the decrease of investor confidence means that investors are taking their money away from riskier assets and moving it to low-yield government securities. This again implies troubles for the EMs which find it harder to borrow on the international market as their bond yields become less attractive to investors. Even though throughout the scope of the Western crisis and recovery some EM countries have been (more or less) robust to the global credit squeeze (it was mainly Europe that suffered, or to be more precise the peripheral Europe), this was mainly thanks to the rise of China as the alternative financial superpower. However as the Chinese growth model slows down, its vulnerabilities get exposed, and as the West recovers, imposing tighter monetary policy, the financial crisis-related problems are re-emerging for the EMs. 

It's hard to blame the EMs for this, since the global crisis was hardly their fault. But it makes sense to blame them for not adjusting to this problem when it became rather obvious. 

A missed opportunity 

Over the past few decades one can actually speak of a fairly convenient position the EMs were in: high commodity prices, low global interest rates (recall  the famous Bernanke's global savings glut), large exposure to foreign financing (inflow of capital), and more prudent domestic macro policies (such as central bank policies aimed at lowering inflation). It's no wonder they experienced rapid growth rates. 

But the real question is how have their domestic governments used this favourable position? Back in July last year, in the midst of the many protests arising simultaneously in several EM countries (Brazil, Turkey, Egypt, Indonesia, Bulgaria), I suggested that the largest issue for all these countries has been the fact that they failed to utilize on the strong growth they had in the pre-crisis decade. Years of above average growth rates have been accumulated mostly by the political and corporate (crony) elites, not the majority of the population. This of course causes great distress in the population which can culminate in even the slightest detail (such as the increase of bus fares in Sao Paolo or a construction site at a park in Istanbul). 

When anti-government protests combine with worsening macroeconomic conditions, then an obvious reaction from the financial markets is to punish such behaviour. In particular to punish political instabilities, lack of reforms and downright cronyism that lead to macro vulnerability and weakening currencies. Financial markets fear the possible descent of these countries into further depreciation spirals, rising inflation and interest rates, problems of debt repayments and consequentially a full-blown financial crisis. 

Apart from institutional reforms the policymakers in emerging markets must think of good short-term macro remedies. Most of these can be solved jointly by a pledge to reform a crony system which would send a clear signal to the financial markets of the (anticipated) stability of these countries, which may very well turn the tide in a different direction. Some positive examples imply this is possible (Mexico, Malaysia, Chile), even though there's still a long way to go. 

The "original sin"

The FT however is far more pessimistic reporting that the EMs are still characterized by all the same troubles they had back in the 90s: "dollar-denominated debt backed by local-currency revenues (the so-called 'original sin')". They report a rapid rise of cross-border bank lending but even more importantly a rapid expansion of private sector bond issuance (see the figures below). 

Source: FT: Nomura and BIS.
Some explanation is needed here: "It is standard practice for central banks to identify issuers by country of 
residence rather than nationality – so that if the Brazilian subsidiary of Banco Santander, for example, issues 
a bond, it will appear as part of the private sector debt of Brazil rather than of Spain. And if an overseas
 subsidiary of a Brazilian company issues a bond in, say, the Cayman Islands, it will appear in the debt
 of the Cayman Islands, not of Brazil." FT, Feb 7th 2014
Furthermore the FT reports:
"...over the past decade ... the amount of debt issued by EM corporations through overseas subsidiaries has grown quickly – adding substantially to the stock of original sin. Pretending it is not there does nothing to reduce the vulnerability of the ultimate issuing nation.
Drilling down a bit further, we see that while the bulk of such issuance has come from governments and banks, in some countries – India and China stand out in our sample – a significant part of the increase has come from non-financial corporations (NFCs).
Hyun Song Shin and Laura Yi Zhao, in a recent paper from Princeton, argue that, especially in China but also in other countries such as India, Indonesia and South Korea, such issuance constitutes surrogate financial intermediation and has contributed to the stock of credit available in those countries."
Which brings us to the bubble story in China (its enormous shadow banking system) and the rising vulnerability and exposure of the EM countries to China's problems. Even though China is a bubble waiting to burst, its burst may not turn out to be so devastating (at least for them) if  higher consumption steps in to replace the malinvestment bubble. But their temporary decline in growth is already causing problems for many EM countries. If China goes into a full financial crisis (no matter how quickly it may recover), the EMs are likely to suffer much more than in the post-2008 period. This can once again lead us to conclude that, regardless of the buffer you're using, unsustainable foreign-denominated debt, coupled with political instability and state capture of democracies, always get punished by financial markets. 

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