Is another EM crisis on the horizon?
Is another EM crisis on the horizon?
Alongside the human toll, only now beginning to climb in many emerging markets (EM), the coronavirus pandemic poses another crisis risk for EM. A global flight to safety, damaging to all risk assets, entails additional macroeconomic risks for economies heavily reliant on US dollar financing. While all economies are under stress at this moment, EM economies face additional unique pressures to which their developed market peers are not subject.
Dollars are becoming increasingly hard to come by as global trade shrivels amidst the shutdowns, tourism collapses, banks and other international lenders become unwilling to lend given the outlook and increased repayment risk, and portfolio flows dry up in the global dash for cash.
Why dollars are important to EM
Dollars are important to EM because the currency has become increasingly dominant in both global trade and finance. The bulk of EM trade, for example, is invoiced in dollars, meaning economies could begin to struggle to buy essential imports of food and energy.
Meanwhile, turning to credit, the dollar is dominant in many EM financial systems, as the chart below highlights. There are some exceptions – European EM are roughly equally reliant on euro financing, and a happy few have minimal external debt in any currency – but in general it is clear that a more expensive dollar will have repercussions for EM borrowers.
Evidence of this stress has been plentiful in market indicators. Dollar funding costs soared in March, with the cost of borrowing dollars outside of the US much higher than for a US based borrower; a good barometer of financial stress.
Why has demand for dollars surged?
Part of the problem has been a surge in demand for dollars from financial institutions as the desire to hedge rises with financial market volatility, which has coincided with a demand for dollars from the real economy. US corporates have drawn down credit lines as the US shutdown intensifies, diminishing the ability of US banks to supply dollars to the rest of the world.
What has been the impact of the dollar strength in EM?
This demand for dollars has also been visible in the behaviour of the dollar index; the value of the dollar relative to a basket of major currencies. That the stress is more concentrated amongst EM is reflected by the relative moves of the US Dollar Index (the DXY), and a broad EM currency index (the JP Morgan Emerging Markets FX Index), as illustrated in the chart below.
We are also beginning to see some evidence of capital outflows in the reserves data, with a sharp fall in the figures from nine early reporters for March. The fall, particularly ex-China, is far in excess of normal monthly volatility, and even for China marks a break from the last three years. This suggests currency weakness would be greater if not for central bank intervention
How the Fed is providing support to some EM
Still, things could have been even worse. The global financial crisis saw measures of funding costs and stress in the international financial system at more elevated levels than today. Perhaps part of the reason for this is the more rapid response of the Federal Reserve (Fed).
On this occasion, the Fed has been quick to expand swap lines with other central banks, effectively swapping dollars for other currencies for an agreed time period. Those central banks can then supply dollars to their own financial systems, reducing the strain on markets.
While this has certainly calmed nerves in developed markets, essentially closing the gap between what foreign and domestic borrowers of dollars must pay, only a few EM are lucky enough to have access to a Fed swap line. At the time of writing, only Brazil, Mexico and South Korea can make use of this facility, with a cap currently of $60 billion each. The rest of EM must make do with a repo facility, which requires holdings of US Treasuries to access, and does not boost the total dollar firepower of those countries.
If access to dollars is curtailed, central banks in EM will have to fall back on their reserves. Luckily, learning from past crises, most EM central banks have adopted a monetary policy framework combining inflation targeting with FX reserve accumulation. This means they have more leeway today to allow currency depreciation to bear the brunt of macroeconomic adjustment, thanks to low inflation expectations anchored by years of sound policymaking, and greater buffers to cushion the economy. As we saw above, this depreciation already appears to have begun.
How prepared are EM central banks for a crisis?
The question for investors might then be which EM economies have sufficient resources to survive in the face of so many coincident pressures. Countries will need hard currency reserves sufficient to cover lost revenues from exports, to cover essential imports, counter capital flight, repay or rollover maturing debt and to at the very least smooth the volatility in their exchange rates.
The IMF has provided a methodology for an assessment of reserve adequacy incorporating these considerations, based on the experience of past crises. We show where major EM economies stand today relative to this measure of reserve adequacy, inclusive of the swap line support from the Fed, where applicable.
Anything below 100% is an immediate red flag, and on this basis Turkey, Chile and South Africa all look to be at risk. We would include Hungary in this bracket, but with the caveat that they are more reliant on euro than dollar financing and will likely have ample support from the European Central Bank. Indonesia is also in the danger zone with reserves only slightly above the minimum. The rest of EM looks well prepared.
Note, however, that this measure of reserve adequacy assumes countries are happy to allow their currencies to absorb the shock. A fixed exchange rate regime, or even a managed float, would see a downward revision of a given country’s level of preparedness. The measure also assumes no capital controls, which would work in the opposite direction.
Which EM are most at risk?
The countries to the left of the chart then are in a better position to defend their currencies and might be expected to see less pronounced falls than those on the right, which will have little option but to stand aside – particularly Turkey – unless they implement some form of capital controls. The longer the disruption to the global economy, and its financial system, continues, the more likely such a path becomes.
 Advjiev, S., Egemen, E., McGuire, P., “Dollar funding costs through the Covid-19 crisis through the lens of the FX swap market” BIS Bulletin No. 1, April 2020
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