Hard times till 2011

Hard times till 2011
The Financial Express, April 23, 2009, Page 7

Net private flows to emerging markets peaked at 5% of emerging market GDP in 2007. However, the credit crunch in mature markets will likely cause significant outflows by banks in the coming years, as cross-border lending comes to a halt and a number of parent banks may begin curtailing financing to emerging market subsidiaries. An econometric analysis suggests outflows by banks could reach 5% of GDP in many emerging European countries, where cross-border bank inflows soared to unsustainable levels in recent years. Such outflows would not be without precedent.

Banking outflows of this magnitude were seen in some countries during the Latin American debt crisis in the early 1980s and again during the Asian financial crisis in 1997-98.

Emerging markets experienced large portfolio outflows at the end of 2008, and outflows are likely to continue over the coming years, given continued pressures for leveraged investors to shed assets, the risk of further redemptions from emerging market funds and crowding out from government guaranteed mature market bonds. We project annual portfolio outflows of around 1% of emerging market GDP over the next few years. Foreign direct investment in emerging markets is set to slow significantly, given diminished appetite from private equity firms, the lack of credit available to finance acquisitions, and sharply deteriorating cyclical growth prospects in emerging markets.

On balance, emerging markets will likely see net private capital outflows in 2009, with slim chances of a recovery in 2010 and 2011.

Moreover, risks to these projections appear to be to the downside, given how protracted the current global crisis is likely to be.

The global credit crunch has reduced the investor base for emerging market assets Emerging market assets under management by hedge funds have dropped by about half from their peak in early 2008 as these funds have faced severe redemption pressures, exacerbated by negative performance, and reduced leverage. In the fourth quarter of 2008, withdrawals accounted for nearly one-third of the total $23 billion decline in assets under management. Retail investors have also withdrawn, with dedicated emerging market bond and equity funds experiencing substantial outflows, losing several years worth of inflows in the second half of 2008—a magnitude similar to the outflows seen in 1998.

Surveys suggest crossover investors have shifted heavily away from emerging markets into mature market corporate bonds, including government-guaranteed debt, amid a reevaluation of the diversification benefits from emerging markets as theories of “decoupling” proved wrong. Over the longer term, market participants believe emerging markets will retain a core of institutional investors committed to strategic allocations. The reduction in the number of investors, however, combined with the disappearance of some broker-dealers, is likely to impair the liquidity of emerging market assets for several years to come.

And when the crisis engulfed emerging markets...

Pressures on emerging markets intensified in September 2008, following the collapse of Lehman Brothers, as counterparty risks rose and as the credit crunch’s impact on economic activity became indisputable. A large set of interlinked risks has already pushed some emerging markets into crisis, and threatens many more, particularly in emerging central and eastern Europe.

The severity of the crisis in emerging markets and the risks of spillovers call for a strong and coordinated response from policymakers at a global level to ensure that adequate liquidity is available. The decision taken at the recent G-20 summit to increase the resources available to the IMF can serve as an example in this respect.

Policies should also be aimed at keeping mature market financial institutions engaged, through close cooperation between home and host authorities. Emerging market policymakers, in turn, need to strengthen their financial systems and policies for the more challenging global economic environment.

Crisis risks in emerging Europe have increased sharply...

Emerging Europe has been hit hard by global deleveraging. The impact has flowed through the same financial linkages with mature markets that previously allowed the region to build up a high degree of leverage through rapid foreign-financed credit growth being disrupted as the banking crisis in western Europe intensifies. Growth in credit to the private sector is falling rapidly, intensifying the vicious circle between output declines and deteriorating asset quality.

As a result, external debt spreads have risen sharply, stock markets have collapsed, and currencies have come under pressure, especially in those countries with large domestic and external imbalances. In countries with tightly managed exchange rate regimes, the fear of currency and stock market collapse also risks capital flight, such as that experienced in Russia and Ukraine.

...and financial interconnectedness within Europe increases the risk of adverse feedback loops.

Most emerging European countries are highly dependent on western European banks, which own the majority of banking systems in these countries. Cross-border funding risks are somewhat less acute in Asia and Latin America, given that countries in these regions entered the crisis with generally stronger external balances, larger international reserves, and deeper local funding markets. Still, Asian and Latin American asset prices have fallen substantially over the past three quarters.

The Asian corporate sector looks likely to be hit hard by extremely large drops in trade volumes. Sharp drops in export revenues are leading some companies to burn through cash reserves rapidly, implying that financing needs will pick up. However, foreign financing is increasingly scarce.

Hedge funds that had been a major source of capital for Asia’s corporate expansion are now mostly trying to sell their largely illiquid assets, while foreign banks are deleveraging. Banks in Asia and Latin America are less impacted by the crisis than in emerging Europe, as they are mostly still well-capitalised and locally funded with low loan-to-deposit ratios, but are increasingly concerned about the quality of their loan books and are scaling back working capital financing to corporates.A concern is that funding of bigger corporates will squeeze out small and medium-sized enterprises and new entrants.

The abrupt fall in trade volumes in recent months appears to have been worsened by the disruption in the provision of finance for working capital, including trade finance. The cost of trade finance has increased significantly and its modalities have changed, returning from open-account trade financing to more traditional structures. Many exporters have restricted the credit they are willing to provide their customers as a result of reduced access to capital and heightened concerns about customer credit-worthiness. To address these concerns, the March 2009 G-20 summit committed up to $250 billion to support trade financing through export credit and investment agencies, and through multilateral development banks.

—Excerpted from the Global Financial Stability Report, IMF, April 2009