MacroScan - The International Transmission of Fragility

The April 2009 edition of the IMF's Global Financial Stability Report is categorical. Global financial stability has deteriorated further since its last assessments in October and January, with conditions worsening more in emerging markets in recent months. Within emerging markets, while European countries have been affected most, the problem is acute elsewhere as well with some countries in Asia, which had emerged the growth pole in the world economy, being impacted severely. Thus even a country like South Korea, which is seen as having recovered substantially from the damage inflicted by the 1997-98 crisis, is now experiencing a crisis in its financial sector with feedback effects on the real economy. Examining this Asian face of the crisis does offer some important lessons-once again.

There are many ways in which developing countries have been affected by what began as a developed country crisis. But there are two which are seen as being of particular relevance. One is through the effect of the global slowdown on their exports. This is in some sense unavoidable, though this effect would differ across countries depending on the degree to which growth in individual countries is dependent on exports, especially to developed country markets, and on the degree to which countries can redirect growth away from dependence on export markets to dependence on domestic demand. The second is because of a sudden reversal of capital inflows, with attendant effects on reserves, currency values and liquidity. As the IMF puts it: ''The deleveraging process is curtailing capital flows to emerging markets. On balance, emerging markets could see net private capital outflows in 2009 with slim chances of a recovery in 2010 and 2011.''

The outflows, the IMF estimates, can be substantial. Net private capital flows to countries the IMF identifies as emerging markets peaked at 4.45 per cent of their GDP. This is estimated to fall to 1.34 in 2008 and a negative 0.15 per cent in 2009. Much of this decline and reversal would be on account of portfolio and ''other'' investment, which are estimated to be negative in both years, whereas the flow of FDI is expected to be positive, though smaller. This is not surprising since it is to be expected that the impact would be greater on hot money flows, as the IMF suggests. Heavily leveraged firms faced with redemption pressures, such as hedge funds, have played an important role, with nearly one-third of the $23 billion in assets under the management of such funds in emerging markets having been repatriated in the fourth quarter of 2008. This process of ''deleveraging'' is of course a reflection of the need of international banks and financial firms to withdraw capital from emerging market to meet demands at home.

But it has damaging effects in emerging market countries. Stock markets have collapsed, and currencies are depreciating sharply. When the exit of capital results in a depreciation of the local currency, corporations that have accumulated foreign exchange liabilities in the recent past find that declining revenues and higher local currency costs of acquiring foreign exchange are squeezing profits, delivering losses and even threatening bankruptcies. Banks that have lent to these corporations are recording increases in non-performing assets and are cutting back on credit provision. And the flight of capital implies that consumers and investors who financed large consumption and investment expenditures with credit are being forced to cut back worsening the shrinkage of demand. This is a vicious cycle that drives the downturn in emerging markets, some of which, according to the IMF, have become the focus of the crisis in recent months.

It bears noting that this set of developments linked to capital reversal is surprising given the received mainstream wisdom on the source of the global imbalances that led up to the current crisis. Developing countries, it was argued, especially developing countries in Asia, had turned cautious after their experience with the crises in 1997 and after, and were therefore holding the foreign exchange they earned from net exports as reserves. The resulting global savings glut was accompanied by a flow of capital to the developed countries, particularly the United States, financing not just the current account deficit but also the boom in stock, housing and commodity markets in that country. It was because the resultant excess spending that generated the upswing in goods and asset markets in the US could not be sustained for ever that the boom had to unwind through a process that inexorably led to a recession.

The first problem with this argument is that it misses the fact that in the case of most developing countries, including many of the exceptional performers in Asia (barring cases like China, where net exports were indeed important), the accumulation of foreign reserves was the result of the inflow of capital. Second, this inflow of capital took the form of a supply-side surge driven by financial developments in the developed countries with financial institutions in those countries being the ''source'' of capital. As Chart 1 indicates, the increases in the Cross-Border Liabilities of Banks reporting to the Bank of International Settlements were substantial since early 2005 (even after adjusting for exchange rate changes), with a significant acceleration of such changes between mid-2006 and the first quarter of 2008. An examination of the country-wise break of the location of banks with such cross-border liabilities shows that most of these banks were located in the developed countries and were accumulating substantial liabilities in developing countries as well.
Chart 1 >>

In fact, if we take total external financing in the form of bond financing, equity financing and syndicated loans, there was a significant increase in such financing between 2004 and 2007 in countries identified as emerging markets by the IMF. Further, the share of Asian emerging markets (EMs) was substantial, despite the evidence that European EMs were receiving a large share of such financing (Chart 2). It is only in 2008, when the crisis had set in that we begin to see a decline in flows and that decline was sharp in the last two quarters of 2008. The point to note is that the increased inflow prior to 2008 was not because of any special measures adopted by these countries. Many of them had begun liberalizing their rules with regard to capital inflows in the early 1990s and had gone the distance by the time of the 1997 crisis, after which capital flows to developing countries in Asia were curtailed. The resurgence of inflows after 2004 was not specifically driven by any new policy changes in the recipient countries, but by a push generated by excess liquidity in the source countries. The error on the part of the emerging market countries was that they had not imposed restrictions on capital inflows after the 1997 crisis, making them vulnerable to surges in capital inflows followed by reversals, or to boom-bust cycles of the kind that preceded 1997.

The point to note is that liberalization did not offer any guarantee of capital inflows either in normal times or in times of irrational exuberance. Capital inflows do not necessarily rise sharply immediately after liberalization nor do all countries attract inflows once they liberalize. Thus during the period of the global capital surge beginning 2004, a few developing countries in Asia accounted for an overwhelming share of capital flows to emerging markets in the region. Table 1 shows that the 7 top emerging market recipients of capital inflows received between 85 and 95 per cent of the flows into emerging Asia.
Chart 2 >> Table 1 >>

The crisis in some of these countries is a result of the reduction of these inflows to some of these ''beneficiaries'' of the capital inflow surge. What is noteworthy is that the decline in aggregate external market financing has been accompanied by a sharp fall in mobilization of finance through bond financing, while the fall has been lower in the case of equity financing and syndicated borrowing (Tables 2, 3 and 4). In fact, the relative share of syndicated loans in total private external financing has risen quite significantly across leading emerging markets in Asia. Clearly, emerging market paper was less attractive and a rising share of flows that were occurring were the result of dedicated effort to syndicate loans and ensure some capital inflow.

The evidence that a reversal of flows has been damaging, even in countries that were performing well with strong reserves and reasonably good macroeconomic conditions, demonstrates once again the fragility associated with excessive dependence on external capital inflows. In the circumstance, the case for imposing controls on inflows to reduce the vulnerability that results from global as opposed to domestic developments is strong. But as in 1997, it is unclear today whether countries would absorb the lessons of the current crisis and do the needful. And if a relatively stronger Asia does not, it is unlikely that developing countries elsewhere would do so.
Table 2 >> Table 3 >> Table 4 >>