The 1990s and early 2000s witnessed spectacular and catastrophic financial crises in so-called emerging markets. The Tequila crisis in Mexico in 1994/1995, the Asian crisis in 1997/1998, the Russian default in 1998, a crisis in Brazil the same year, the the slide into crisis and eventual devaluation and default in Argentina in 2001/2002.
Since then, financial flows into emerging markets have more than recovered – they’ve surpassed pre-Asian crisis levels. According to the Institute of International Finance, in 2006 net capital flows to emerging markets reached “$502 billion (…), just below the record of $509 billion in 2005”. This little slide in 2006 is probable to be explained by the 2006 emerging market stock-market turbulence, which, however, seems to already have been forgotten. Global investors are having a big party at the moment. Investment bank Goldman Sachs bonuses averaging around $600.000 per employee last year are one of the manifestations of this global money binge.
The questions are:
1) When will the party end? 2) Why could it happen? 3) Where will it come from? 4) And: Is there a risk of a major contagion?
To start with:
On 1) nobody knows. On 2) Nobody knows either. However, given accumulated experience and knowledge, there are some indications on where the risks can come from. On question 3): risks are everywhere. This week though, Ecuador has drawn particular attention in the global financial industry. And I will discuss the issue in the light of the Ecuadorian case. Regarding question 4): the risk of contagion seems to be less acute today than ten years ago, but it is not excluded and could hit those who really can’t afford it.
How recent financial crisis started and what were their characteristics?
All the crises mentioned above had the following patterns: they were triggered by speculation against pegged currencies by international investors who started to see that the value of the currency did not correspond to realities on the ground: economic fundamentals (Thailand), macroeconomic imbalances such as high budget deficits, inflation, high levels of government debt (Mexico, Argentina, Russia), all this often accompanied by unstable, erratic politics (Argentina, Russia), and compounded by very weak financial systems (undercapitalised banking sector, for example).
A paper by Chiodo and Owyiang (2002) summarises well the factors that can trigger an emerging market financial crisis such as witnessed in 1997-2002. They write:
“four key ingredients can trigger a crisis: a fixed exchange rate, fiscal deficits and debt, the conduct of monetary policy, and expectations of impending default.”
Where do we stand today on these financial crisis risks?
Fixed exchange rates. While before the Asian crisis there was a strong belief that fixed echange rates would bring to emerging markets the necessary stability and predictability, to help them attract investment, reality has shown that the pegs must be considered credible – i.e., the economic fundamentals must support the exchange rate. Emerging economies must at some point make a transition to more flexible schemes, or even to a plain free float. This paper by Sebastian Edwards can give you more detailed insights into the issue. But controversy remains. Emerging market practice shows that there are different policies. There are much more free floats, mainly in countries hit by the abovementioned crises. But some have gone for the most radical form of “peg” – dollarization, i.e., the abolition of the national currency for a stronger one considered stable and credibility enhancing. It is the case of Ecuador, Panama, El Salvador, or of some European countries, like in the Balkans, which work with the Euro.
Fiscal deficits and debts. Here, a general miracle has happened. Emerging market finances seem to be as sound as ever. The Financial Times recently had a full page on “How the developing world is striving to free itself of debt”. It says:
Russia, whose $40bn domestic debt default and financial collapse in 1998 sent shock waves throughout the world, has used its windfall from high oil and gas prices to pay off a large chunk of its foreign debt. Moreover, debt reduction has not been limited to oil exporters: Argentina, historically a serial defaulter – most recently on $100bn worth of debt in 2001 – ended its relationship with the International Monetary Fund a year ago and is paying more money back to creditors than it is borrowing in fresh loans or bonds (…).
Countries scarred by past crises, including Mexico, Brazil, Indonesia, the Philippines, South Korea and other countries in Latin America and Asia have taken steps over the past five years to insulate themselves from the effects of a future global financial crisis. In stark contrast to past periods of strong global growth and low interest rates, they are husbanding resources rather than spending them – many are paying off public debt, running budget and/or current account surpluses and building foreign exchange reserves. When they do issue bonds, governments are increasingly doing so locally rather than in international capital markets.
The conduct of monetary policy. This is related to the above – currently, interest rates are low, and inflation globally at its lowest levels. In general, except for rogues such as Zimbabwe, governments take care not to let inflation get out of control.
Today’s most important risk:
“Expectations of impending default” – Given the above factors, expectations of impending debt default by governments are very low. So, no need to worry? Unfortunately, we still do. This week, Ecuador, surprised international markets by…. paying its scheduled debt on time! This should be good news, but it isn’t necessarily. The Financial Times reported on Friday:
Quito surprised markets (…) by making a $135m (€100m, £69m) bond payment on time – having warned that it would use a 30-day grace period…
With that comes the possibility that Quito will set another dangerous example by becoming the first government to default on its debt even though it has the ability to pay.
The article continues thus:
Patrick Esteruelas, Latin America analyst at the Eurasia Group consultancy in New York, says: “By threatening to default wilfully, Ecuador would be setting a poor precedent that could be followed by other, weightier countries such as Turkey and Poland.” Analysts and foreign investors have pointed out that oil-rich Ecuador is far from being in a liquidity bind, with a debt-to-GDP ratio of just more than 30 per cent – low by emerging market standards. By making yesterday’s coupon payment on time, the government has undermined its own argument that it did not have the funds available.
So: risk of default, and therefore of investor panic, this time does not stem from fundamentals. The single biggest risk of a financial crisis stems from politics.
Interestingly, the analyst quoted by the FT mentions Turkey and Poland – I don’t think Turkey would default on purpose in the foreseeable future. But current Polish politics – in the heart of the EU – do contain risks.
Back to Ecuador: Ecuador’s left-wing president Rafael Correa is obviously seeking electoral support and sending an international message that fighting against poverty is a priority going before repaying rich bankers (with all their Christmas bonuses). Here is an analytical piece that puts the country briefly in political perspective.
Ecuador – one of Latin America’s poorest countries, but one with oil – has missed out on the recent oil-windfall. High oil-prices have not led to interesting levels of economic and income growth or to long-term investments (more here). Instead, a lot of money is spent on short-term relief – e.g. subsidies on … petrol prices. Contrary to countries like Chile and Russia, which have set up well-functioning Stabilization Funds to capture and save the extra cash from commodities (oil, copper, etc.), not only preserving the country against inflationary shocks, but also allowing it to have the proper resources to invest in policies that will pay out in the long term and prepare for periods of low commodity prices, Ecuador has not set up such a tool. The extra cash that still came in will be lost. Russia is scaling up spending on health, education and infrastructure. No investor in Russia I know of (given that I have been working with them for almost two years now, I know what I am talking about) is complaining about that. On the contrary, they welcome it. They only fear that the money could be squandered. Also, Russia is making efforts to diversify away from oil. In the last decade, Ecuador, due to its eternally unstable politics, hasn’t had the necessary conditions to concentrate on well-functioning policies that can, in the long run, help it get out of poverty. The country continues fitting the old-fashioned “dependency” picture of countries eternally trapped in their dependence on volatile commodity markets – with its related mentality: blaming others for what one can’t get right at home. It is interesting to see that the countries which have chosen “self-reliance”, as the FT puts it, have fared better – with diverging policy content ranging from China to Chile, and even, more recently, to Argentina. Ecuador has a point: fighting poverty is a priority, but political short-termism, including souring relationships with international investors, is not going to help. After all, it has not the same weight as Venezuela (which has a lot more oil-money clout, and which, in the international financial markets is still “behaving well”, believe it or not).
The likelihood of contagion
Should something terrible happen with a country like Ecuador – how likely is a crisis to spread somewhere else? It is growingly acknowledged that the category “emerging market” such as established by international portfolio investors in the late 1980s offers a much more differentiated picture today. Quite a lot of countries have become rich, policies and politics have diverged as well, knowledge on these countries has also developed. The prestigious The Banker magazine published a long article arguing that the term emerging market is increasingly a “misnomer”. Also, the Asian and following crises have been a lesson for investors who tend to become more lucid about their famous “herd-behaviour”. Finally many countries have solid economic fundamentals, eliminating much of the “country-risk” investors are exposed to.
In today’s context, the scenario could be thus:
First possibility: No contagion. Ecuador alone will suffer. Not from currency speculation – as its economy is dollarized, but by loss of investor confidence, investor panic, and a damaging soaring cost of borrowing. Given its little weight in the global economy, investors will not worry for their other investments.
Second possibility: Contagion to countries with erratic politics. Populist politics will be punished even more by financial markets. Thus feeding the argument that the global financial system opposes “democracy” (…). So who could be touched: Poland, Hungary, Thailand (again?), Nicaragua… (and maybe.. France?;-))
Third possibility: contagion to the poorest countries. All countries with high levels of poverty will be punished by financial markets. I say this thinking of Africa, which has recently come back onto investors’ radar screens and where some governments have made valuable efforts in their country’s governance.
In reality, nobody knows what can happen, and where a potential crisis will come from. It will probably come from a corner nobody expects. It would be a pity though, that the poorest of the poorest be hit worst…