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.
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.
Table
1: Share of Top Seven in Asian Emerging Market External Financing |
|||||||||
2004 |
2005 |
2006 |
2007 |
2008 |
Q1
08 |
Q2
08 |
Q3
08 |
Q4
08 |
|
China |
16.8 |
20.5 |
22.6 |
25.2 |
15.8 |
19.5 |
15.1 |
15.9 |
7.5 |
Hong
Kong SAR |
12.7 |
10.6 |
11.6 |
7.9 |
8.4 |
4.3 |
8.9 |
14.1 |
6.4 |
India |
8.7 |
11.4 |
13.3 |
19.6 |
20.2 |
25.7 |
14.8 |
18.3 |
22.6 |
Indonesia |
2.7 |
2.7 |
3.8 |
2.7 |
7.5 |
6.6 |
10.9 |
3.5 |
9.4 |
Korea |
20.4 |
25.2 |
17.4 |
20.1 |
18.6 |
19.4 |
25.7 |
10.1 |
16.0 |
Singapore |
7.8 |
7.7 |
8.9 |
6.6 |
11.1 |
9.8 |
11.7 |
13.9 |
7.6 |
Taiwan
Province of China |
17.4 |
10.1 |
10.0 |
8.2 |
9.8 |
10.5 |
5.6 |
11.2 |
15.2 |
| Total | 86.6 |
88.1 |
87.6 |
90.4 |
91.3 |
95.7 |
92.8 |
86.9 |
84.8 |
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: Share of Top Seven in Asian Emerging Market External Financing:
Bond Issuance |
|||||||||
2004 |
2005 |
2006 |
2007 |
2008 |
Q1
08 |
Q2
08 |
Q3
08 |
Q4
08 |
|
China |
17.0 |
9.9 |
2.2 |
2.9 |
7.1 |
0.0 |
3.6 |
24.5 |
0.0 |
Hong
Kong SAR |
17.2 |
23.1 |
14.0 |
22.0 |
15.9 |
17.1 |
16.5 |
18.4 |
1.5 |
India |
24.1 |
9.8 |
9.0 |
13.0 |
3.8 |
1.0 |
15.2 |
0.0 |
0.0 |
Indonesia |
33.1 |
54.2 |
23.7 |
21.6 |
30.5 |
50.5 |
36.3 |
0.0 |
0.0 |
Korea |
57.1 |
37.7 |
47.4 |
37.4 |
43.0 |
27.6 |
53.0 |
55.4 |
38.1 |
Singapore |
47.9 |
29.2 |
24.1 |
22.9 |
10.3 |
5.4 |
27.4 |
0.0 |
0.0 |
Taiwan
Province of China |
1.7 |
4.2 |
1.4 |
0.0 |
0.0 |
0.0 |
0.1 |
0.0 |
0.0 |
Table
3: Share of Top Seven in Asian Emerging Market External Financing:
Equity Issuance |
|||||||||
2004 |
2005 |
2006 |
2007 |
2008 |
Q1
08 |
Q2
08 |
Q3
08 |
Q4
08 |
|
China |
53.6 |
59.8 |
81.0 |
64.0 |
43.9 |
40.8 |
60.4 |
22.6 |
72.8 |
Hong
Kong SAR |
19.2 |
20.4 |
23.6 |
24.3 |
13.5 |
4.4 |
36.1 |
2.2 |
2.5 |
India |
37.8 |
39.6 |
37.3 |
32.9 |
15.8 |
29.8 |
12.8 |
2.1 |
0.5 |
Indonesia |
20.6 |
25.7 |
8.0 |
33.0 |
16.9 |
6.8 |
27.7 |
24.1 |
0.0 |
Korea |
17.1 |
26.4 |
18.9 |
10.3 |
6.5 |
9.8 |
5.1 |
0.0 |
9.7 |
Singapore |
21.8 |
27.5 |
22.2 |
21.4 |
0.2 |
0.0 |
0.1 |
0.0 |
1.5 |
Taiwan
Province of China |
12.8 |
37.6 |
16.0 |
19.9 |
4.7 |
1.0 |
2.6 |
13.9 |
0.0 |
Table
4: Share of Top Seven in Asian Emerging Market External Financing:
Syndicated Loans |
|||||||||
2004 |
2005 |
2006 |
2007 |
2008 |
Q1
08 |
Q2
08 |
Q3
08 |
Q4
08 |
|
China |
29.4 |
30.3 |
16.8 |
33.1 |
49.0 |
59.2 |
36.0 |
52.9 |
27.2 |
Hong
Kong SAR |
63.6 |
56.5 |
62.4 |
53.7 |
70.5 |
78.5 |
47.4 |
79.4 |
96.0 |
India |
38.2 |
50.6 |
53.8 |
54.1 |
80.4 |
69.2 |
72.0 |
97.9 |
99.5 |
Indonesia |
46.2 |
20.1 |
68.3 |
45.4 |
52.6 |
42.7 |
36.0 |
75.9 |
100.0 |
Korea |
25.7 |
35.9 |
33.7 |
52.3 |
50.5 |
62.6 |
41.9 |
44.6 |
52.2 |
Singapore |
30.3 |
43.3 |
53.7 |
55.7 |
89.6 |
94.6 |
72.5 |
100.0 |
98.5 |
Taiwan
Province of China |
85.5 |
58.2 |
82.7 |
80.1 |
95.3 |
99.0 |
97.3 |
86.1 |
100.0 |