Emerging markets were going to weather the storm … but will they survive the hurricane?

Source: http://www.dbresearch.com/
The financial breakdown of the west has spilled over to the emerging economies and these economies face a sharp economic contraction, led by :

• declining FX reserves,
• battered financial systems,
• a pronounced weakening of real economic activity.
• sharply slowing exports,
• plummeting commodity prices and
• sizeable capital outflows

The global financial dislocation has also exposed financial vulnerabilities in a number of smaller EMs, forcing several of them to request IMF financial support:

At the beginning of the crisis, the EM-6 had enough official FX reserves to cover their 12-month external financing requirements. This is generally regarded as a comfortable position.
However, this metric does not capture

1. all potential sources of balance-of-payments pressure
2. equity liabilities,
3. off-balance sheet liabilities related to cross-border derivatives transactions
4. resident capital flight.

Nonetheless, the comfortable external financing positions theoretically mean that as long as the authorities refrain from “financing” these types of outflows by drawing down their FX reserves, the countries will have sufficient funds to stay current on their debts falling due over the next 12 months, albeit at the risk of substantial currency depreciation in the event of, for example, substantial resident capital flight.

Two important sources of balance-of-payments pressure have weakened since the onset of the crisis.

1. The value of foreign portfolio holdings in the EM-6 has declined substantially on the back of large Q4-2008 outflows,
2. dramatic equity market correction and/or significant currency depreciation; and losses related to off-balance sheet transactions seem to have been largely realized.

Further EM-6 FX liquidity has stagnated or declined in recent months, only Mexico’s 12-month financing requirements now exceed its FX reserves (but only very slightly).

Resident capital outflows in the EM-6 should remain manageable as the risk of a sovereign default or a systemic banking crisis is low – and as long as the authorities devalue the exchange rate and allow domestic interest rates to rise.
This also applies to Russia, where FX reserves have fallen most, the current account is being hit the hardest and which has seen the largest resident capital outflows.

A scenario of how the (near) future will pan out for the EM-6
In a typical crisis, capital inflows recover after a while, allowing EMs to avoid drawing down all their external assets.
Uncertainity:

• But what if this time is different and the EM-6 only have very limited access to external capital markets over the next 12-24 months?
• What if capital-constrained financial institutions and spooked investors in the advanced economies remain reluctant to lend to EMs?
• What if banks that have tapped government bail-out programmes encounter significant political opposition to extending funding to EMs?
• What if the huge amount of expected fiscal-stimulus and bail-out related sovereign and sovereign-guaranteed debt issuance in the developed markets leads to a diversion of funds away from EMs?

One possible consequence of any of these / or a combination of these uncertainity panning out is :
Some combination of sizeable FX reserve buffers, bilateral swap agreements and access to the IMF’s short-term liquidity facility should provide the EM-6 with enough time to adjust their current account positions by way of a further (substantial) currency devaluation and a further (sharp) slowdown in economic growth.

The EM-6 economies are being battered and are already seeing a sharp deceleration in economic growth. The economic slowdown could become even more pronounced, should they remain shut out of international capital markets for longer than expected and be forced to adjust their balance-of-payments more drastically on the current account side. The recent Brazilian and Mexican sovereign bond issues have raised some hope that this can be avoided. However, under either scenario a systemic financial breakdown looks unlikely.
But no one knows if it will.