Vulnerabilities in the Emerging World

As the U.S. recession is pushing the rest of the world into hard landing, the large imbalances in several economies – whether deficits or surpluses, high external debt or currency risks – make these countries vulnerable to a crisis and painful re-adjustment.

Eastern Europe tops the list of emerging market regions susceptible to a full-blown financial crisis. Unlike emerging markets elsewhere, Eastern European economies are heavily dependent on external financing and current account deficits have been the norm. So, the sharp drop-off in capital inflows - expected in 2009 - will not only be a major blow to growth, but it could also potentially trigger a regional financial crisis. The Baltics, Bulgaria, Romania and Hungary stand out as particularly vulnerable but a crisis in one country could trigger a regional domino effect.

The strong foreign banking presence in the region, long hailed as a strength, now increasingly looks like a potential weakness. Depending on the country, foreign banks hold about 60-90% market share. These foreign parent banks, under pressure from the global financial crisis and slowdowns in their home countries, are reducing lending to their Eastern European offspring. In an extreme (albeit unlikely) scenario, there is the risk that foreign parent banks, in the face of rising defaults and prohibitively expensive refinancing, would pull out of these markets.

In recent months, the IMF has agreed to dole out more than $18 billion in emergency loans to Hungary and Latvia. Since most economies in the region have similar vulnerabilities, the question is: Who could be next?

Estonia and Lithuania look to be headed down the same path as Latvia and may also be forced to turn to the IMF for help. All three boomed in recent years, at times posting double-digit growth rates, helped by cheap credit and strong capital inflows in conjunction with their EU membership in 2004. While Latvia is in the worst shape of the three due to a wider current-account deficit (the region’s largest in 2007 at almost 24% of GDP) and higher external debt, the other two Baltics are in similar straits. Like Latvia, they have double-digit current-account deficits, which make them especially vulnerable to the drop-off in capital inflows. Whereas these current account gaps were once funded primarily with FDI, this is changing, as evidenced by the buildup of external debt.

Despite strong public finances and very low government debt levels, all three Baltics suffered credit downgrades in recent months as their huge gross external financing requirements make them vulnerable to a cut-off in capital flows. Fitch put Latvia’s financing needs at around 400% of end-2008 foreign exchange reserves, 350% in Estonia and 250% in Lithuania - the highest ratios in Emerging Europe. Adding to their vulnerabilities, all three Baltics have fixed exchange rates which combined with external imbalances ostensibly make them susceptible to currency crises. Despite some pressure on the pegs, Baltic governments have shown absolutely no appetite for devaluations. Latvia, for example, lobbied hard to to keep its peg as part of its IMF agreement.

Bulgaria’s key vulnerability is its massive current-account deficit, which Moody’s expects to widen to around 23% of GDP in 2009, making it the region’s highest – and like others in the region is increasingly debt financed. Bulgaria’s external debt-to-GDP ratio is particularly high, above 100%. Like Estonia and Lithuania, Bulgaria runs a currency board, which the government staunchly supports. One strength - the government runs one of the biggest budget surpluses in Europe (projected at 7.5% of GDP in 2009) - a distinct contrast from fiscal deficits elsewhere in the region. And unlike the Baltics, Bulgaria is still expected to post positive growth in 2009 of around 2%, although its vulnerabilities pose substantial downside risk.

Once high-flying, Romania is poised to slow sharply to around 2% in 2009, but simmering vulnerabilities pose significant downside risks and an outright financial crisis cannot be ruled out. In recent months, S&P and Fitch cut its sovereign credit ratings to ‘junk’ status. On top of its double-digit current-account deficit (the 5th highest in the region), the country’s budget deficit is ballooning and is forecast to breach the 3% Maastricht Treaty limit in 2009. While external debt –about 60% of GDP in 2008 - is still moderate compared to Bulgaria and the Baltics, FDI coverage has been on a steady decline, meaning external debt will likely continue to rise rapidly. Unlike Bulgaria and the Baltics, Romania has a flexible exchange rate, but it’s unlikely to be a significant cushioning tool since it like most other CEE countries, has a high degree of foreign currency lending. Any significant depreciation of the leu would result in the insolvency of a great number of Romanian households and businesses, potentially posing a risk to financial stability.

Hungary secured a $25.5 billion loan package from the IMF, EU and World Bank in October 2008 to avert crisis. While the package may have alleviated external financing risks in the near-term, Hungary still has a long list of underlying vulnerabilities (examined in detail in an RGE post in October), which means the country could still be susceptible to crisis down the road. Hungary continues to suffer from twin deficits and high foreign currency lending, which could affect financial stability and constrain monetary policy. Unusual for the region, Hungary has a high government debt to GDP ratio of an estimated 73% - far and away the highest in the region. Long a regional growth laggard, GDP may contract 3% in 2009.

Despite a strong banking system and a prudent fiscal target for 2009, Serbia's vulnerabilities are growing. The current-account deficit, at an eye-catching 18% of GDP in 2008 is among the highest in the region while the currency has declined 20% since October 2008 despite repeated central bank interventions. As a precautionary measure, Serbia reached a $520 million standby agreement with the IMF in November 2008 which it is hoped will help stave off crisis in the face of the sharp re-adjustment.

Also worrying are the vulnerabilities in Serbia's western neighbor - Croatia. The large external debt (at around 90% of GDP), current account deficit (around 10% of GDP), and short-term financing needs of the government and corporate sector are key challenges given the tighter global financing conditions. To bolster investors’ confidence, Croatia’s government may also seek a precautionary program from the IMF.

While Turkey is headed towards an economic contraction, an outright financial crisis should be averted. Turkey is close to signing a deal with the IMF, which will reassure foreign investors and rein in government spending. The IMF package is expected to be in the range of $20-25 billion, although there is some concern at the fact that an agreement has not yet been announced. While Turkey’s banking sector is in much better shape following the 2001 crisis, its current account deficit (forecast at about 5% of GDP in 2008) and heavy external financing requirements make it vulnerable to tightening global credit conditions. According to S&P, Turkey’s external financing requirement stands at around 140% - one of the higher ratios among emerging markets.

Oil exporters like Russia, Kazakhstan and several GCC countries are now facing a reversal in their fiscal and current account balances which are shifting into deficit territory. Ample savings from the oil boom will now be drawn down to support growth and in many cases help the corporate and financial sectors pay off their large foreign debts accrued during the boom years. For GCC countries, the real vulnerability is their contingent liabilities, accrued through support of the financial system. Dubai corporates have been particularly hard hit by the credit crunch and their exposure to the domestic property markets.

Of the GCC countries, the UAE has the highest short-term debt relative to forex reserves which leaves it highly vulnerable. Its short-term external debt as a share of total external debt is expected to rise to 72.5% in 2009. Other vulnerability indicators put it among the worst in the Middle-East and well above the average of developed economies. It will likely call on its savings in 2009 to finance its spending as its current account also shifts into a deficit – Look for Abu Dhabi to support Dubai. Kuwait too is vulnerable, with its banks struggling to find new sources of finance in the face of defaults and Kuwaiti corporates facing investment losses. Kuwaiti financial institutions have already suffered some defaults, and further ratings downgrades are possible. Kuwaiti political divergence could also increase the difficulty of responding to the crisis.  By contrast, Saudi Arabia may be least vulnerable given its ample reserves, conservative investment strategy and well-capitalized banking sector.

While Russia is unlikely to default on its sovereign debt, its corporate and financial sector debts now outstrip its stock of foreign exchange reserves ($386 bn in mid-January 2008). Although 2008 refinancing was accomplished, more than $110 bn in foreign debt will come due in 2009 and the depreciation of the rouble raises the risk of a cascade of non-payments.  Russia’s economic indicators have quickly reversed along with oil prices and the country is likely to run its first 'twin deficit' in a decade in the midst of a sharp economic contraction in 2009. The fall in the value of the rouble, lack of finance, and the plunge in consumption (jobs are being shed at a faster pace than during the 1998 financial crisis) are also causing imports to contract which may limit the deterioration of the current account. Yet, the rapid depletion of reserves and use of the assets in its wealth and reserve funds to finance its fiscal deficit (a deficit of as much as 10% of GDP is possible in 2009) may trigger further ratings downgrades. All of this is likely to weigh on the rouble which has crashed through the new trading band.

Like Russia, Kazakhstan saved the bulk of its oil windfall, but Kazakh banks and companies borrowed heavily and have now turned to the government for funds. Kazakhstan will thus be left with little cushion if commodity prices continue to be weak through 2009-10. Further capital flight is possible if oil prices remain at current levels - uncertainty about the value of the tenge, which is likely to be devalued, could trigger a speculative attack putting pressure on the fragile banking system that is struggling to meet or roll over the foreign debts due for repayment in 2009. Kazakhstan was one of few oil exporters to run a current account deficit routinely during the boom years, and this deficit will widen in 2009.

Ukraine will see the sharpest slowdown in Eastern Europe in 2009 with a growth contraction of at least 6%. Its terms of trade is set to deteriorate further due to weak external demand and prices for key exports, especially metals. With steel exports falling along with the slowdown in FDI inflows, balancing the current account will be a major challenge in 2009. Yields on Ukraine’s $105.4 bn of government and corporate debt are amongst the highest for any country with dollar-denominated debt. If the hryvnia-dollar exchange rate widens further, mass loan defaults are expected. The latest gas accord with Russia increases Ukraine’s spending on gas by almost 7% at a time when Ukraine’s economy is surviving on the first installment of the IMFs $16.4 bn bailout. The IMF fiscal conditions are likely to rein in social expenditure including likely public sector wage arrears in 2009, deepening the Ukraine’s political divisions.

Similarly, Belarus received a $2.5 bn IMF credit line as adverse terms of trade, falling demand for its exports and lack of external financing led to a sharp decline in the country's forex reserves. To stop the reserves outflow and increase competitiveness, the Central bank devalued the Belarusian rouble by 20%, one of the IMF’s requirements.

Egypt and Israel are likely to see current account surpluses shift to deficit as weak demand from the US and EU reduces exports and – growth rates. Israel’s public finances are deteriorating significantly, growth is slowing and finance drying up. Many of Israel’s technology companies are also financed by the U.S. The fiscal deterioration is a risk as the 2008 budget diverged from its target, and the outlook might worsen further in 2009. Israel has a rising public debt to GDP ratio which might turn into a serious vulnerability.

With volatile portfolio inflows the main source of finance in the face of falling FDI, South Africa will find it difficult to finance its large current account deficit (almost 8% in Q3 08). The Rand, which already depreciated nearly 25% in nominal terms in 2008, is vulnerable to further devaluation in 2009 given the wide current account gap and slowing growth, making it one of the most vulnerable currencies in emerging markets. South Africa could potentially face a further onslaught on its trade balance as global demand continues to fall. Meanwhile, consumption will slow sharply with income erosion from inflation, high debt levels, still-high interest rates and concerns about job security doing little to offset external demand weakness.

Turning to Asia, China may not be at the risk of default but its economic indicators continue to be weak and its liabilities are on the rise. Real GDP growth might fall to half of the recent 10% average as exports contract, investment slows and domestic demand falters - despite the government’s fiscal stimulus.  China already ran a small fiscal deficit in 2008 as spending, especially on earthquake reconstruction, increased and slowing economic growth, declining profits and tax cuts eroded revenues. Meanwhile, attempts to prime the pump by encouraging bank lending could add to non-performing loans on banks' balance sheets even as the property slump has reduced the underlying asset value. Despite China’s export contraction in Q4, its trade surplus is at a record high as imports have contracted more. For sustainable growth, China needs to boost domestic consumption, alleviating domestic and global imbalances and overcapacities by reducing its savings rate. While the stimulus cannot fully offset the decline in domestic and foreign demand, funds for health, education and other payments could boost consumption and a stronger RMB in real terms could increase the purchasing power of Chinese workers. These changes may not happen overnight - not with an estimated 20 mn job losses - but are a part of China’s future trajectory. A smaller current account surplus, would likely mean lower reserve growth, especially if capital outflows persist - and fewer purchases of U.S. assets.

The perilous state of South Korea's balance of payments stems from the banking system's shift into deleveraging mode after years of funding a buildup of overcapacity in the construction and real estate industries. If it weren't for the currency swap agreement with the Federal Reserve, the $7.8 bn decline in the overall balance of payments deficit would have been much smaller in December 2008. Though short-term external debt repayments continue to rise, the $7.3 bn drop in Korea's capital and financial account deficit leaves plenty of room to reduce external debt further from its 2008 peak of $425 bn. Meanwhile, Korea's current account posted a $6.41 bn deficit in 2008. Korea will struggle to pull out of its deficits without strong cyclical tailwinds from domestic and external demand, neither of which look likely to materialize this year. Policy responses have forestalled an external debt and currency crisis for now. Foreign exchange reserves stand at nearly $202 bn as of end-January 2009, enough to cover short-term external debt. But the rapid economic contraction lingers and threatens to intensify the domestic liquidity squeeze. Asset quality deterioration in both the corporate and household sectors has prompted banks to tighten lending while global risk aversion keeps debt markets dysfunctional. Rate cuts by the Bank of Korea have helped lower banks' lending and funding costs since November 2008 but, like in the U.S. and Europe, Korean banks have yet to recirculate the government funds pumped into the financial system. If foreign investors resume dumping Korean equity and debt holdings en masse while Korea undergoes deleveraging and economic restructuring, financial crisis concerns may resurface.

Political crisis and stock market plunge in Pakistan in 2008 led to large portfolio outflows causing forex reserves to fall to $3.45 bn and the currency to plunge 21%. Ratings downgrades amid risk of financing the current account deficit and external debt payments led to the $7.6 bn  IMF bailout. However, highly negative real rates, slowing growth along with political confrontations with India and reassessment of relations with the new U.S. administration will continue to hamper capital inflows in the short-term. Slowing remittances and FDI with easing textile exports to U.S. and EU will keep the current account and balance of payments in deficit while external debt servicing due in 2009 will also be a challenge. But $4 bn of IMF funds to be disbursed in 2009 and other funding from multilateral agencies and strategically important countries such as China and U.S. will curtail risk of crisis or default, especially since global leaders view Pakistan's economic failure as a risk to the region's stability and security. Moreover, in recent weeks, stability of the new government, impact of lower subsidies, oil prices and import demand on the twin deficits, a stabilization fund for the stock market and improving equity valuations have somewhat helped calm investor sentiment if not improve it.

Upcoming elections have raised stimulus and other government spending, leading Indonesia to seek $5.5 bn in loans from multilateral agencies and bilateral donors such as Japan and Australia to finance its fiscal deficit. The oil and commodity price correction has significantly hit export and government revenues. While slowing import demand will contain risks to the trade and current account surpluses, negative income balance and continued debt and equity outflows might push the balance of payments into deficit, putting further pressure on the currency. This will be exacerbated by the policy rate cuts and slowing capital inflows which accounted for over 50% of domestic investment and stock market holdings. The central bank will continue to sell forex reserves to defend the currency, posing a risk to the high government and private foreign-currency denominated debt. But if risks to the internal and external balances escalate and global credit crisis continues to dampen government bond issues, Indonesia might seek additional bilateral and multilateral loans to avoid  IMF assistance that would rekindle memories of the 1997-98 bailout.

Vietnam faced ratings downgrades in 2008 owing to risks of overheating, currency crisis and large external financing needs. Policy measures have abated these risks but in the coming months, slowing exports to the U.S. and related FDI inflows will weigh down on the trade and current account deficits. Deteriorating oil exports will put pressure on the fiscal deficit as well. All this at a time when FIIs continue to exit the stock market and the recent FDI boom is being hit by global liquidity crunch, pushing the forex reserves down. However, slowing export related imports and low level of external debt in general will contain risks to the external financing needs. Nonetheless, increase in banks' non-performing loans from equity and real estate market slump will pose risk to the inherently weak banking sector with large dollarization.

Turning to Latin America, Argentina faces a challenging financial outlook in 2009 from three main sources: lower commodity prices, a protracted recession, and excessive fiscal largesse ahead of the 2009 parliamentary elections. Argentina also faces the risk of stagflation in 2009. Financing concerns in Argentina have risen to levels not seen since 2001 as lending rates jumped, credit risk surged and overall uncertainty increased.  If policy discipline prevails, the government may still be able to maintain adequate fiscal surplus levels but finances are tight. The latest move to nationalize the local pension fund will provide a significant amount of resources, which may allow the government to remain current on its debt obligations in 2009 and in the medium term. However, the negative outlook for the economy will continue to raise concerns of default risk. The Argentine government recently announced that 97% of the domestic investors, holding $4.3 billion in "guaranteed loan" bonds maturing over the next two years, have agreed to swap these instruments for new debt (Bonar bonds with a maturity date of 2014). The swap will save Argentina around $1 billion in the short term, making it easier for Buenos Aires to finance the roughly $20 billion in debt repayments due in 2009.

In December 2008, Ecuador announced a default on part of its external debt (Global 2012). Unlike the Argentine situation in 2001, the reason for default is more political than economic. In the last two years, Ecuador has used an expansionary fiscal policy to the point that public expenditure has increased over 30% per year and the subsidies consume more than $5 billion per year. The unbalanced external accounts, liquidity restrictions and the fiscal budget requirements show rapid deterioration. If Ecuador continues with expansionary fiscal policy, fighting against the international community, adopting laws against the markets (tax reform, financial reform among others) and postponing economic reforms, dollarization might cease to exist. If the government changes the direction of economic policy reducing expenditures, fiscal subsidies and giving more friendly signals to the international economy, dollarization might be sustained. Indeed, the election scheduled for May 2009 will guide the costs behind these adjustments.