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Wednesday, November 5, 2008

Why emerging economies need bailout help?

The financial crisis that originated in the reckless financial engineering and practices of investors and borrowers in the US, is now starting to adversely affect the emerging markets. Some of the possible effects on these economies have been analyzed in a previous post here.

While the East Asian economies have been relatively unscathed by the financial crisis, thanks to their lower exposure to external borrowings and massive domestic savings, many East European and Latin American economies have already been deeply affected by the credit crunch. Like the East Asian economies in the late nineties, these economies, attracted by the cheap capital outside and apparent strength of their local currencies, too drew up massive external commercial borrowings that drove their current account deficits to unsustainable levels. Most of the countries in this category have low domestic savings, and depend on foreign capital to finance their trade and investments and have also borrowed heavily in foreign currencies.

The crisis in US and Europe and the attendant deleveraging then triggered off repayment pressures and depreciation of the domestic currencies (which magnifies their loans), which in turn leaves them vulnerable to defaults and bankruptcies. For example, roughly 30% of Hungary’s public debt and about 60% of loans to businesses and individuals are denominated in foreign currencies, making the country vulnerable to a drop in its currency.

In this context, there have been strong calls for the IMF to step in as a lender of last resort to provide liquidity to emerging economies facing acute short-term liquidity crunch. As Dani Rodrik argues, with the extent of the crisis deepening, it is natural that both the financial markets and the real economy in the emerging economies mimic the demands in US, where both Wall Street and Main Street are being bailed out. However, unlike the US, with its almost unlimited ability to draw upon resources for such bailouts, the emerging economies are constrained by their fragile fiscal balances and limitations of monetary policy interventions.

Accordingly, the IMF created a new short-term liquidity facility (SLF), with no conditions attached, to channel funds quickly into emerging markets that have a strong track record, but that need rapid help during the current financial crisis to get them through temporary liquidity problems. This facility would lend upto $100 bn to healthy countries that are having trouble borrowing as a result of the turmoil in the global markets. The Fund has already reached bilateral agreements with Iceland ($2.1 bn), Hungary ($15.7 bn), and Ukraine ($16.5 bn) to extend short-term credit support.

Under the program, countries could borrow five times the amount they are normally entitled to — $25 billion, in Brazil’s case — without the strict conditions, like demands to raise interest rates and cut public spending, that normally accompany such loans. While the loans are for just three months, they can be rolled over three times, giving the countries close to a year to cover shortfalls.

In addition the the US Federal Reserve committed up to $30 billion each to the Central Banks of Brazil, Mexico, South Korea and Singapore, to enable those countries to more easily swap their currencies for dollars, and thereby increase the dollar liquidity in emerging markets.

This may also be an opportunity for China to signal its ability to exhibit leadership at times of global crisis. The Chinese government should consider lending a small portion of its massive $2 trillion reserves, through its Sovereign Wealth Fund (SWF), to embattled companies and governments in these economies. Such steps, apart from enhancing the credibility of the Chinese government, will also directly benefit the Chinese economy, which is already feeling the pinch of weakening global demand (its exports will decline) and falling global equity and debt markets (returns on its foreign exchange surplus investments are very low).

Update 1
Dani Rodrik makes as strong case for the IMF or somebody providing large amounts of liquidity support to the emerging markets, both to support their currencies and provide credit support to their corporate sector. He is right in pointing out that these economies are presently facing the consequences of the recklessness and greed of Wall Street, despite maintaining healthy fundamentals. Further, the public guranatees given to their financial sector institutions by the governments in US and Europe have had the effect of marking out the emerging market assets as relatively more risky and thereby exacerbating the flight from these economies.

I particularly liked his description of the pressures being felt by emerging market currencies as arising from a "rational flight to safety, exacerbated by an irrational panic".

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