Into the maelstrom – Emerging markets in the financial turmoil

November 3, 2008

It’s very hard to keep up with the current financial crisis… The speed of the spread is dazzling. Banks, governments, companies, currencies, commodities, people’s savings, all dragged into the whirlwind. So, the financial crisis is now hitting emerging markets. Eastern Europe is badly hurt, not least because its financial sector is owned by Western European banks. Hungary had to reach out to the European Central Bank and to the International Monetary Fund. The IMF is generally back in fashion, even for the the unlikely likes of Paul Krugman and Dani Rodrik. But the amounts available in its coffers are dwarfed by the sovereign reserves by key emerging markets. The IMF is for example probably getting a helping hand from Saudi Arabia….  China’s rulers are getting very nervous because their country’s economy is slowing down to “only” 8% GDP growth this year. Russia is said to be likely to weather the crisis, thanks to its accumulated reserves, but it is going to have rough times ahead. Some are even outright alarmist. As regards emerging markets, whoever has time to go through the IMF’svery good World Economic Report will have a sober analysis of the fundamentals in the situation. Same for the Global Financial Stability Report (I haven’t had time for all chapters…!).

For those who want something shorter I recommend a recent testimony before the US Congress by Simon Johnson, former IMF Chief Economist, now at MIT and at the Peterson Institute in Washington. The piece not only summarizes and explains many of the recent events, it also proposes policy solutions for the US (a strong stimulus package). More interestingly in this context: he shares a few views on what is going to happen to the world’s emerging markets.

Who’s being hit?:

Four sets of countries stand to lose.

  1. The over-leveraged. With bank assets more than ten times its GDP, Iceland cannot protect its banks from a run. Other countries that borrowed heavily during the boom face a similar situation.
  2. The commodity-dependent. Oil has already fallen below $70 per barrel, and demand continues to fall. All other major commodities are falling for the same reasons. Commodity exporters facing sharply reduced revenues will need to cut spending and let their currencies depreciate.
  3. The extremely poor. Sub-Saharan Africa, which was a beneficiary of the commodity boom, will be hit hard by the fall in commodity prices. At the same time, wealthy nations are likely to slash their foreign aid budgets. The net effect will be prolonged isolation from the global economy and increased inequality.
  4. China. The global slowdown has already had a major impact on several sectors of China’s manufacturing economy. The collapse in the Baltic Dry Index shows that demand for commodities and manufactured goods is plummeting. While China’s economic influence will only grow in the long term, a global recession could cause a severe crimp in its growth.

In short: just about everybody…. What’s going to happen next? Johnson continues:

In just the last week, the outlook for emerging markets has gotten significantly worse. As the wealthiest nations protect their banking sectors, investors and lenders will be less likely to put their money in countries perceived as risky. Iceland is already facing default, either by its banking sector or by its government. After Iceland, the psychology of fear is likely to take over as creditors try to guess which country will be next, just as in 1997–98. Unless a country has a sufficient balance sheet and a very large amount of reserves, it may get drawn into a pattern of selective defaults and large devaluations.

The IMF is stepping in with aid packages to Iceland, Ukraine, and Hungary. However, it is hard to see how the IMF or anyone else can provide resources on a sufficient scale to make a difference. Investors expect multiple countries across Eastern Europe to default, judging by the price of credit default swaps on those countries’ debt.

Falling commodity prices due to the coming recession will also hurt many exporting countries. Even Russia, with its large foreign currency reserves (and vast oil and gas reserves) may have a significant mismatch problem between short-term liabilities and longer-term assets. This is complicated further by large private-sector debt in foreign currency. The government may be moving toward deciding which companies it will save. Hopefully, for the companies it does not support, it will be possible to have an orderly workout.

The currency crisis that has blossomed over the last week is only exacerbating the crisis. As emerging-market currencies fall, their foreign debts become more and more unmanageable, increasing the risk of default. Whether because of the unwinding of the carry trade or because of old-fashioned flight from assets that are falling in value, the currency crisis has become self-perpetuating.



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