Financial Crisis

EVEN now, not every central banker is terribly impressed by the gravity of the financial crisis that has spread from Western banks to the emerging worlds shares, currencies and credit markets. In India the United Forum of Reserve Bank Officers and Employeesthe central banks staff uniondecided that October 21st was a good moment for its 25,000 members to abandon their posts in a dispute over pensions. The Reserve Bank of India (RBI) denounced it as an illegal strike. The union called it mass casual leave. A few months ago, many emerging economies hoped they could take mass casual leave from the credit crisis. Their banks operated far from where the blood was being shed. The economic slowdown evident in America and Europe was regrettable, but central bankers in many emerging economies, such as India and Brazil, were busy engineering slowdowns of their own to reverse high inflation. They were more interested in the price of oil than the price of interbank borrowing.

This detachment has proved illusory. The nonchalance of the RBIs staff, for example, is not shared by the central banks top brass, who, a day before the strike, cut the banks key interest rate from 9% to 8%, having already slashed reserve requirements earlier this month. Their staffs complaint about pensions looked quaint on the day that Argentinas government said it would nationalise the countrys privatepension accounts in what looked to some like a raid to help it meet upcoming debt payments. The IMF, which has shed staff this year because of the lack of custom, is now working overtime (see article). The governments of South Korea and Russia have shored up their banking systems. Their foreign-exchange reserves, $240 billion and $542 billion respectively, no longer look excessive. Even Chinas economy is slowing more sharply than expected, growing by 9% in the year to the third quarter, its slowest rate in five years. The emerging markets, which as the table shows enter the crisis from very different positions, are vulnerable to the financial crisis in at least three ways. Their exports of goods and services will suffer as the world economy slows. Their net imports of capital will also falter, forcing countries that live beyond their means to cut spending. And even some countries that live roughly within their means have gross

liabilities to the rest of the world that are difficult to roll over. In this third group, the banks are short of dollars even if the country as a whole is not.

Long before Lehman Brothers went bankrupt in mid-September, prompting the worlds money markets to seize up, the currencies of commodity exporters had already started to tumble. South Africa, a huge exporter of platinum and gold, has seen its currency fall further than any other this year except the Icelandic krona. Russias rouble peaked on July 16th as oil prices fell, and the Brazilian real began to slip a couple of weeks later. Brazils commodity exports amount to 9% of its GDP, according to Lombard Street Research, a firm of analysts. But its commodity firms, such as the oil giant Petrobras, account for over 40% of the stockmarket. Thus the fall in commodity prices has hit the bourses hard. A similar fate befell Russia, where the main indexes were already in decline after the countrys military misadventures in Georgia. India and China benefit from cheaper oil. India, for example, spent almost two trillion rupees ($48 billion) on crude imports in the five months from April to August. But even as their import bills fall, their export earnings are slowing. On October 22nd Tata Consultancy Services, Indias biggest information-technology company, announced that its net dollar profit in the latest quarter was almost 7% below the quarter before. Indias IT bosses are worried about getting paid by

banks for work they have done for them. Goldman Sachs says that Indias trade deficit will subtract 1.5 percentage points from its GDP growth this fiscal year and next. Indias exports will be helped by a declining rupee. Chinas yuan, on the other hand, has held its own against the dollar, even as the greenback has strengthened recently. It may find itself reprising its stabilising role during the Asian financial crisis, when it held fast to its dollar peg, even as its neighbours and competitors suffered currency collapses. Stephen Green of Standard Chartered calculates that Chinas trade-weighted exchange rate, adjusted for inflation abroad and at home, is now at its strongest since 1989. Morgan Stanley reckons the shares of emerging economies have never been as oversold. But foreign investors have punished some economies more harshly than others. The market for credit-default swaps, which insure against default on sovereign bonds has, for example, distinguished between countries running big current-account deficits (over 5% of GDP) and other more abstemious places. Of the four biggest emerging markets, Brazil, Russia, India and China, India has the largest current-account deficit, which widened to 3.6% of GDP in the second quarter. It bridged most of this gap with foreigndirect investment. But its globe-trotting companies also rely on raising money abroad, borrowing $1.56 billion externally from April to June. This borrowing has since become far more expensive. Russia has a hefty surplus on its current account, not a deficit. It earned $166 billion from oil and gas exports in 2007. Its economy should be flush with hard currency. In fact, Russias companies and banks are now scrambling to find dollars. The overseas liabilities of Russian banks now exceed their foreign assets by $103.5 billion (excluding net foreign direct investment in the industry), according to the countrys central bank. The country is not awash with petrodollars because the state taxes its energy earnings heavily, and sequesters its dollar takings in its central-bank reserves and its Stabilisation Fund. As Rory MacFarquhar of Goldman Sachs has pointed out, Russia accumulated $560 billion in foreign-exchange reserves from 2000 to mid-2008, even as its banks and companies have added $460 billion to their external debt. Russia, in effect, lends dollars to Western governments, then borrows them back again from Western banks.

Now those Western banks are suddenly reluctant to lend, which means Russias government will have to close the dollar-circuit itself. The central bank will deposit $50 billion of its foreign-exchange reserves in the state-owned Vnesheconombank, which will, in turn, lend that money to companies and banks faced with imminent foreign-debt payments. There is an irony here. The Wests financial institutions have long been hoping for sovereign-wealth funds, flush with petrodollars, to arrive as saviours. But Russia, at least, now needs all its sovereign wealth to save itself.

The financial crisis

Into the storm

Oct 23rd 2008 From The Economist print edition

How the emerging world copes with the tempest will affect the world economy and politics for a long time

FOR much of the past year the fast-growing economies of the emerging world watched the Western financial hurricane from afar. Their own banks held few of the mortgage-based assets that undid the

rich worlds financial firms. Commodity exporters were thriving, thanks to high prices for raw materials. Chinas economic juggernaut powered on. And, from Budapest to Braslia, an abundance of credit fuelled domestic demand. Even as talk mounted of the rich world suffering its worst financial collapse since the Depression, emerging economies seemed a long way from the centre of the storm. No longer. As foreign capital has fled and confidence evaporated, the emerging worlds stockmarkets have plunged (in some cases losing half their value) and currencies tumbled. The seizure in the credit market caused havoc, as foreign banks abruptly stopped lending and stepped back from even the most basic banking services, including trade credits.

Like their rich-world counterparts, governments are battling to limit the damage (see article). That is easiest for those with large foreignexchange reserves. Russia is spending $220 billion to shore up its financial services industry. South Korea has guaranteed $100 billion of its banks debt. Less well-endowed countries are asking for help. Hungary has secured a 5 billion ($6.6 billion) lifeline from the European Central Bank and is negotiating a loan from the IMF, as is Ukraine. Close to a dozen countries are talking to the fund about financial help. Those with long-standing problems are being driven to desperate measures. Argentina is nationalising its private pension funds, seemingly to stave off default (see article). But even stalwarts are looking weaker. Figures released this week showed that Chinas growth slowed to 9% in the year to the third quarterstill a rapid pace but a lot slower than the double-digit rates of recent years.

Blowing cold on credit

The various emerging economies are in different states of readiness, but the cumulative impact of all this will be enormous. Most obviously, how these countries fare will determine whether the world economy faces a mild recession or something nastier. Emerging economies accounted for around three-quarters of global growth over the past 18 months. But their economic fate will also have political consequences. In many placeseastern Europe is one example (see article)financial turmoil is hitting weak governments. But even strong regimes could

suffer. Some experts think that China needs growth of 7% a year to contain social unrest. More generally, the coming strife will shape the debate about the integration of the world economy. Unlike many previous emerging-market crises, todays mess spread from the rich world, largely thanks to increasingly integrated capital markets. If emerging economies collapseeither into a currency crisis or a sharp recessionthere will be yet more questioning of the wisdom of globalised finance. Fortunately, the picture is not universally dire. All emerging economies will slow. Some will surely face deep recessions. But many are facing the present danger in stronger shape than ever before, armed with large reserves, flexible currencies and strong budgets. Good policy both at home and in the rich worldcan yet avoid a catastrophe. One reason for hope is that the direct economic fallout from the rich worlds disaster is manageable. Falling demand in America and Europe hurts exports, particularly in Asia and Mexico. Commodity prices have fallen: oil is down nearly 60% from its peak and many crops and metals have done worse. That has a mixed effect. Although it hurts commodity-exporters from Russia to South America, it helps commodity importers in Asia and reduces inflation fears everywhere. Countries like Venezuela that have been run badly are vulnerable (see article), but given the scale of the past boom, the commodity bust so far seems unlikely to cause widespread crises. The more dangerous shock is financial. Wealth is being squeezed as asset prices decline. Chinas house prices, for instance, have started falling (see article). This will dampen domestic confidence, even though consumers are much less indebted than they are in the rich world. Elsewhere, the sudden dearth of foreign-bank lending and the flight of hedge funds and other investors from bond markets has slammed the brakes on credit growth. And just as booming credit once underpinned strong domestic spending, so tighter credit will mean slower growth. Again, the impact will differ by country. Thanks to huge currentaccount surpluses in China and the oil-exporters in the Gulf, emerging economies as a group still send capital to the rich world. But over 80 have deficits of more than 5% of GDP. Most of these are poor countries that live off foreign aid; but some larger ones rely on private capital. For the likes of Turkey and South Africa a sudden slowing in foreign financing would force a dramatic adjustment. A particular worry is eastern Europe, where many countries have double-digit

deficits. In addition, even some countries with surpluses, such as Russia, have banks that have grown accustomed to easy foreign lending because of the integration of global finance. The rich worlds bank bail-outs may limit the squeeze, but the flow of capital to the emerging world will slow. The Institute of International Finance, a bankers group, expects a 30% decline in net flows of private capital from last year.

A wing and a prayer

This credit crunch will be grim, but most emerging markets can avoid catastrophe. The biggest ones are in relatively good shape. The more vulnerable ones can (and should) be helped. Among the giants, China is in a league of its own, with a $2 trillion arsenal of reserves, a current-account surplus, little connection to foreign banks and a budget surplus that offers lots of room to boost spending. Since the countrys leaders have made clear that they will do whatever it takes to cushion growth, Chinas economy is likely to slowperhaps to 8%but not collapse. Although that is not enough to save the world economy, such growth in China would put a floor under commodity prices and help other countries in the emerging world. The other large economies will be harder hit, but should be able to weather the storm. India has a big budget deficit and many Brazilian firms have a large foreign-currency exposure. But Brazils economy is diversified and both countries have plenty of reserves to smooth the shift to slower growth. With $550 billion of reserves, Russia ought to be able to stop a run on the rouble. In the short-term at least, the most vulnerable countries are all smaller ones. There will be pain as tighter credit forces adjustments. But sensible, speedy international assistance would make a big difference. Several emerging countries have asked Americas Federal Reserve for liquidity support; some hope that China will bail them out. A better route is surely the IMF, which has huge expertise and some $250 billion to lend. Sadly, borrowing from the fund carries a stigma. That needs to change. The IMF should develop quicker, more flexible financial instruments and minimise the conditions it attaches to loans. Over the past month deft policymaking saw off calamity in the rich world. Now it is time for something similar in the emerging world.