Thursday, October 23, 2008

Roubini On Emerging Markets' Risks

You cannot afford to ignore Nouriel Roubini nowadays, especially since he has been so correct over the past 12 months. Roubini has now latched onto the risks spreading to emerging markets' debts and balance sheet frailty. First thing first, Malaysia is not on the list (phew), but Indonesia, South Korea and India are. How do these risks play out in the mentioned countries? The currency will be under immense pressure, local rates will have to jump sky high to protect value and flight of capital, foreign investment will dry up quickly, short term foreign investments will flee, government and corporate bonds will be downgraded, cost of borrowing will jump, companies on high leverage will suffocate ...

Today we focus on those emerging economies that are falling victim – or are at risk of falling victim – to the ongoing global financial crisis. The escalation of the crisis revealed or exacerbated existing vulnerabilities, such as current account deficits, that were ignored when times were good - ie capital was plentiful. Emerging Market sovereign bond spreads over U.S. Treasuries have risen significantly, more than doubling since late August. Several emerging economies – including Iceland – are in talks with the IMF or regional institutions to provide capital in the face of the global liquidity shortage. While it is still unclear what the role the IMF will have in resolving the crisis, there is no doubt that the debate on its role in international crisis management has been revived.


Iceland has been at the forefront of the global credit crisis. What was essentially a banking crisis has turned into a national crisis as Iceland’s banks appear too big for the government to rescue.

Highly leveraged, Iceland’s banks heavily relied on wholesale funding to finance their aggressive expansion abroad. With the rapid depreciation of the local currency and the seize-up of credit markets, Iceland’s banks were having trouble refinancing their debt and appeared headed for collapse when the government stepped in and nationalized the three biggest lenders.

Now reports suggest Iceland’s government is poised to announce a reported $6 billion rescue package from the IMF. While such a package would be a positive step in providing liquidity, there is no question that a severe economic contraction is coming. Some analysts predict Icelandic GDP could shrink by 5-10% after almost 5.0% growth in 2007.


Also hard hit by the global credit crisis is Hungary. While it’s not suffering a banking crisis a la Iceland (in the sense that its banking sector is mostly foreign-owned, rather than made up of highly leveraged, internationalized domestic banks), it is similar to Iceland in that the global credit crisis has exposed long-simmering vulnerabilities. High levels of foreign currency lending, slow growth (1.3% in 2007), twin deficits (both current account and budget), and heavy reliance on non-deposit foreign funding all contributed to making Hungarian assets sell-off targets.

The ECB came to Hungary’s rescue last week, saying it would lend as much as EUR5 billion ($6.7 billion) to Hungary’s central bank to help revive the local credit market. But the verdict is still out on whether the ECB credit line and government measures are enough to prevent Hungary from becoming an ongoing hotspot.

Given Hungary’s woes, eyes are focusing on the rest of Eastern Europe for signs of trouble. The slowdown in the region’s key export market, the Eurozone, is expected to dent growth across the region. Meanwhile, high current-account deficits and widespread foreign currency lending are particular risk factors. Poland and the Czech Republic are considered among the least vulnerable, but they are far from immune. Meanwhile the Baltics, Bulgaria, and Romania have long been on analysts’ radar as particularly weak links.


All three Baltics (Estonia, Latvia, and Lithuania) boomed over the last seven years and posted double-digit growth rates at their peak, helped by cheap credit from Scandinavian parent banks and EU membership in 2004. Before the the global credit crisis reached fever-pitch, these economies were already headed for a sharp slowdown, with Latvia and Estonia now officially in recession.

There is no question that the global credit crisis will exacerbate the Baltics' slowdown, but will it lead to an Iceland-level crisis? The risk is that foreign capital inflows could dry up and lead to an even sharper slowdown that could infect the financial sector and trigger devaluations. But there are some factors that suggest the sharp slowdown might not evolve into a full-fledged, Iceland-level crisis. For one, external deficits in the Baltics are funded to a large extent by inflows from Swedish parent banks, and sharply cutting off credit would not be in these banks' best interest. Two, substantial foreign ownership of banking assets limits the governments’ contingent liabilities, as Swedish parent banks would be expected to provide support to their Baltic subsidiaries if they get into trouble. Three, the Baltics’ sharp slowdowns have led to speculation that devaluations (they have exchange rate pegs to the euro) could be in the offing. While devaluation cannot be completely ruled out, such fears may be overblown as these countries tend to have shallow financial markets, relative little hot capital, and successfully defended against speculative attacks earlier this year. Nevertheless, without devaluations, these countries' external competitiveness will likely continue to erode, which will impact their growth prospects.

Bulgaria and Romania

Bulgaria and Romania – the so-called ‘gravity defiers’ – are also on the short-list of CEE economies most at risk of being the next hotspots in the global credit crisis. Despite massive current-account deficits (projected to hit 23% of GDP in Bulgaria and 16% of GDP in Romania this year), booming credit growth, and high inflation, these economies have not hit slowdown mode yet – hence the term ‘gravity defiers’.

In the case of both countries, the financing of their current-account deficits has deteriorated, with foreign direct investment (seen as less subject to reversal than other forms of financing) only plugging about a third of Romania’s current account gap and over half of Bulgaria’s. As a result, these economies are highly susceptible to capital outflows, which would trigger a harsh real adjustment.

Another risk is these countries’ high degree of foreign currency lending, particularly notable in Romania which has a flexible exchange rate, meaning unhedged borrowers are highly exposed to currency swings. Romanian households’ high levels of foreign currency lending are similar to those in Hungary (55% in Romania vs. 60% in Hungary of total household loans). And like Hungary, Romania has a budget deficit of over 2% of GDP. Meanwhile, Bulgaria has a budget surplus, which potentially gives its government more room to maneuver if outflows trigger a sharp slowdown. Bulgaria and Romania will be key countries to watch as the global credit crisis unfolds.


The negative effects from the credit crunch on the Balkan region have been limited so far. Growth has remained strong, ranging between 4.3% for Croatia and 8.2% for Serbia in Q1 08. Nonetheless, the significant widening of the current account deficit experienced by most of the countries is a source of concern as both external credit and FDI inflows are likely to slow. Croatia may feel severe pressures since it has the highest foreign debt in the region, at 90% of GDP, and the share of foreign currency mortgages and personal loans is near the level seen in Hungary.


A number of analysts have cited Turkey as particularly vulnerable to global market turmoil given its large current account deficit. At 5.8% of GDP in 2007, Turkey’s deficit – while substantial – is lower than many of its emerging Europe peers. The financing quality, however, has deteriorated of late and it will be important to watch how this trend evolves. Compared to other CEE countries, however, Turkey is less likely to face a bank-related credit squeeze, since the banking sector is relatively liquid with a loan-to-deposit ratio well below 100% and since wholesale borrowing is a smaller fraction of banking sector liabilities. So while Turkey is not immune to the global credit crisis and will experience slower growth, it is much better placed than earlier in this decade to weather the storm.


Ukraine’s high reliance on external finance makes it particularly vulnerable in this global economic downturn and credit crunch, leading it to seek financial assistance from the IMF. Worsening macroeconomic fundamentals including persistent inflation and a widening trade deficit and domestic and regional political uncertainty have contributed to deposit outflow, tighter domestic money market rates and exchange rate volatility, increasing near term risks for Ukraine's banking sector. The value of the Ukrainian currency, the hryvnya, sank by 20% so far in October forcing the National Bank of Ukraine to intervene and sell dollars at an artificially low rate. Moreover, the equity markets fell over 70% this year.

South Africa

Despite a growth rebound to 4.9% in Q2 2008, South Africa cut its growth forecast to 3% for 2009 on worries that a global recession would depress export demand (especially of metals) and investment inflows needed to finance its current account deficit. The fall in commodity prices has pressured the Rand, which fell to its lowest level since 2003, and domestic equity markets. The South African Reserve Bank left its benchmark interest rate unchanged at 12% for a second consecutive time, even after inflation reached a record 13.6% in August. Meanwhile, President Thabo Mbeki's resignation ushered in a period of political and economic uncertainty.


The UAE is one of several oil exporters starting to feel the pinch from the reversal of speculative capital that flowed in early this year to bet on currency revaluation. Long-term project finance costs already tightened throughout the GCC earlier this year and the freezing of global credit markets exposed UAE banks which financed rapid credit growth with foreign not local borrowing. As a result, local interbank rates more than doubled to over 4.6% despite liquidity injections and a central bank liquidity provision for UAE banks. However, although Dubai’s liabilities might be much greater than its assets, most participants and ratings agencies still assume that the federal government (read Abu Dhabi, home of the largest sovereign wealth fund) will step in if they get into serious trouble. Yet, with the oil price and capital inflows falling the UAE’s surpluses and will be smaller next year even if its budget still balances and worries about Dubai’s property market are looming.


Despite its oil wealth, a reliance on short-term borrowing by its banks abroad has left Kazakhstan, one of the few oil exporters to run a current account deficit, exposed. However, unlike some of its neighbors, it will use domestic funding including the $27 billion National Oil Fund to cushion its economy. But with the oil price dropping and new output delayed, Kazakhstan is set for much slower growth next year, particularly as its previously bubbly property market is cooling quickly.


Pakistan, recently hit by a political crisis, is also on the verge of a balance of payments crisis as large capital outflows and decline in forex reserves – below-adequacy levels – pose risk to finance the oil-led ballooning fiscal and current account deficits, and external debt payments. To prevent debt default, the government is seeking $10-15bn in loans from IMF, ADB and World Bank and might approach strategic donors like Saudi Arabia and China. The stock market and currency slump have also led to liquidity injections by central bank along with restrictions on stock trading, short selling, and the establishment of a stabilization fund.


A single day double-digit plunge in stock indices in early-October pulled down Indonesia’s stock market and helped push the index down over 40% year to date, leading authorities to suspend trading and ban short-selling. Capital outflows, rupiah decline and credit tightening have invited central bank intervention in money and currency markets. But the rundown of forex reserves poses significant risk to the subsidy-laden fiscal deficit and commodity correction-hit current account. Balance of payments risks are only exacerbated by the high foreign-currency denominated debt causing the government to seek loans from World Bank and other multilateral institutions.

South Korea

South Korea is the most vulnerable of Asian countries to a sudden stop of financial flows. Korea looks set for another financial crisis given its vulnerabilities that include: the highest loan-to-deposit ratio in the region, rapid growth of short-term foreign debt, a current account deficit, a slowing property market, high food/fuel prices squeezing small- and medium-sized enterprises in the construction industry as well as consumers and large corporations facing an export slowdown. Its currency is down roughly 30% year-to-date despite the announcement of a bank support package as foreign investors have pulled out of Korean assets in a flight-to-safety and de-leveraging that marks the global credit crisis. Many fear Korea's credit crisis will shape up to a repeat of 1997 but others believe that, due to its large war chest of forex reserves and its status as net creditor to the world, Korea's interbank dollar funding squeeze is unlikely to become a 1997 redux. The most worrisome sources of a potential Korean credit crisis are not the foreign currency bank debt built up from hedging exporters' USD shorts and the interest rate arbitrage that resulted as a by-product. Such foreign debt can surely exacerbate the de-leveraging that Korea’s bank sector faces, however the real fire starter for a Korean crisis is domestic debt. Korea needs to restructure after having over-invested in construction/real estate companies and over-lent to households. With a slowing economy endangering asset quality, Korean banks will need to get pickier about who they loan to.


The global financial meltdown has put Argentine's private pension assets in jeopardy. Argentina's government could move to take over the management of $28.7 billion in private pension funds that sharply declined in value this year due to global turmoil. The government is attempting to increase the pool of money it can borrow from in order to meet debt obligations next year. As of now, retirement and pension fund administrators manage private pension accounts for 9.5 million depositors, of which some 40% are active contributors. Essentially, most mandatory funds flow into the private pension system would now become part of the government's pay-as-you-go public pension scheme. Besides that, the government would have access to some USD 1.2bn per year in new flows currently deposited in the system. The idea of using social security funds to avoid a default (or to pay the debt) next year should cause a sharp drop in confidence in the country and in its government.


In Venezuela, the key problem is the fact that its sovereign wealth fund, known as Fonden, holds about $300 million in debt instruments that Lehman had agreed to cash. With Lehman’s bankruptcy, Venezuela will have a hard time selling the debt. Moreover, the Venezuelan's sovereign wealth fund has a significant amount ($2billion) allocated in structured notes that have lost part of their value amidst crumbling markets, and therefore they are hard to cash to cover expenses. Meanwhile the fall in the oil price may crimp Venezuela’s fiscal expansionism.


Although the BRIC economies are not as vulnerable as these over-exposed and smaller Emerging markets, they do not appear immune to the global economic downturn and credit crunch.

The financial crisis has triggered downwards revisions in economic growth in Brazil for 2009. While the country is set to post 5.1% this year, the forecast for 2009 is 2.8%. The financial crisis and decline in commodity prices which tent to reduce the amount of exports contribute to lower growth.

So far, Russian consumers have remained insulated from the loss of wealth in the equity market and troubles that Russian banks face in rolling over their debt, but growth is likely to slow to 5-6% next year from 7% plus in 2007. Meanwhile financing costs are on the rise, eating into corporate profits and the falling oil price may limit a planned investment spree, particularly as a large amount of Russia’s savings are tied up in the domestic banking sector and attempts to avoid a bust in the Moscow property sector.

India is taking a severe hit from the global financial crisis with the stock market down over 50% year to date, FII outflows crossing $10bn and the currency plunging over 20% year to date. While the central bank is injecting liquidity, easing bank credit and capital inflows, cutting policy rate to contain risks to the financial sector and downtrend in asset markets, correction in the near-term seems inevitable. Double-digit inflation, high interest rates and global liquidity crunch will significantly impact domestic demand and industrial activity in 2008-09 pulling down the recent boom. Moreover, twin deficits, both approaching 10% of GDP, pose a challenge as forex reserves decline.

Q3 marked the fifth consecutive slowing of Chinese real GDP growth. Slowing industrial production and real fixed investment are suggesting more weakness ahead particularly if the worst consumer sentiment since 2003 persists. Slowing growth implies fewer commodity imports – even if government sponsored infrastructure projects pick up some slack – clouding the outlook for countries like Brazil, Chile and Australia, among others. The Chinese government fiscal and monetary responses, which have already begun, could cushion its fall and aid in its rebalancing. Yet falling asset prices are taking their toll on local and national fiscal coffers and corporate profits and consumption could be the next shoe to drop as robust retail sales may not stand up to slowing income growth.

p/s photo: Son Dam Bi


ctchoo said...


Very ominous scenario. But, we need this kind of hard truth more than the drivelling nonsense that some politicians dish out to a naive and unsuspecting public. Thanks for the heads up.

lsb said...

this is really interesting. never was there ever such a coordinated acts to shore up confidence. and it will take me a long time to decipher the effects it is having on the market and on the underlying real economy.

see said...

Should be no problem for Roubini, he can dust off his old posts for the Asian crisis....yeah maybe old terms like transparency, cronyism, etc will resurface....maybe he should use it on the US, no double standards right?

CSK said...

Some critics said its unfair to use EPF's money to buy undervalued shares in KLSE, but i am doing a Nouribi here, maybe this step can give a Mahathir Fixing US Dollar(1997)results in few years time.

Lets see how some funny and lucky decision can help the situation since the most logical, high common sense and supposingly smart Americans cannot do it

clk said...

It will be interesting to see which of these Nations will close the door via capital controls. This is probably the only pill not prescribe yet in the last few weeks using the textbook from 1997.

HollyS said...


It is very discomforting to know that markets and countries all over are failing, especially with South Korea, Indonesia and Thailand so near to us. I can't help to realised the fact that when foreign funds sell emerging markets, Malaysia will be dragged along with the rest of the other countries mentioned. There is no escaping the fury out there and at the the same it did not make a single sense that US Dollar is the preferred holding currency. Just because US Dollar was formerly a default currency to the gold standard, does not mean it is now. With the on going financial tsunami generated from the Land of Uncle Sam, the ripple effects are being felt all over the world. I do hope that Malaysia can withstand this crisis better than the rest of the pack but hope is a failure of action from the government who is supposed to govern and not supposed to give false hope to those who have an interest in this country.

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