Primary Surpluses and sustainable Debt Levels in Emerging Market Countries: 5

Emerging-Market Financial Crises: Lessons and Prospects

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By a currency mismatch, I mean a situation where the difference in the currency denomination of assets and liabilities is such that a change in the exchange rate has sizeable effects on an entity's net worth or net income. Why do I put such emphasis on currency mismatch? There are three reasons. It was there in Mexico in , in the Asian crisis countries in , in Russia in , in Brazil in and , in Turkey in , and in Argentina in Second, currency mismatch provides the best explanation we have for why large exchange rate depreciations in emerging economies have had such costly growth effects.

When financial liabilities are mostly denominated in dollars or in other reserve currencies while assets and revenues are mainly denominated in local currency, then a large depreciation of the local currency will result in balance sheet problems that ultimately cause economic growth to nosedive. Third, when an emerging economy is a net debtor in its foreign exchange position and has a large currency mismatch, it will be very reluctant to allow the exchange rate to depreciate significantly, thereby losing the shock-absorbing advantages that go with exchange rate flexibility.

Primary Surpluses and sustainable Debt Levels in Emerging Market Countries

The degree of real exchange rate overvaluation is important because the more overvalued the exchange rate, the higher the probability that the currency will suffer a sharp decline that will activate currency mismatches. And a weak banking system makes it less likely that the credit expansion that often goes with large capital inflows will go to the right borrowers. We have seen all too often how these three factors interact during the buildup and ignition of a currency crisis.

II. Currency and Debt Crises: Why Have Things Changed?

When the good economic news that attracted the inflow turns sour, capital flows out, the overvalued local currency plunges, net foreign liabilities soar, bankruptcies multiply, the banking system comes under strain, aggregate demand crashes, and economic growth falls. All this implies that if we are seeing a big decline in the frequency and severity of currency crises, it ought to because some of these key factors driving crises have improved relative to earlier periods. And this is what we in fact observe. One popular measure of aggregate mismatch that combines currency and liquidity elements is the ratio of short-term external debt to foreign exchange reserves.

For the four Asian crisis economies-Thailand, Indonesia, Korea, and Malaysia-that ratio was in the range of 80 to percent at the onset of the crisis; it is now in the percent range. Philip Turner of the Bank for International Settlements BIS and I have also produced a measure of aggregate currency mismatch for 21 emerging economies that is much more comprehensive than the short-term debt to reserves ratio Goldstein and Turner That measure too shows very large reductions in aggregate currency mismatch for most emerging economies; increasingly, those economies also now have net creditor-not net debtor-positions in foreign exchange.

Operating in a similar direction, today's resurging net capital inflows to emerging economies have a higher share of net foreign direct investment flows than in the inflows of the s IMF a. More recipients of large capital inflows also are running current account surpluses-not deficits. There remain some cases of highly overvalued real exchange rates but fewer in economies with large currency mismatches.

And with much, much larger stocks of international reserves than before, the temptation to engage in pro-cyclical monetary and fiscal policy responses to a decline in reserves is much attenuated. There are many factors behind this reduced vulnerability to currency crises. Suffice to say that-in addition to the benign global environment of high growth and abundant international liquidity-part of the improved picture reflects a shift toward greater reliance on domestic bond markets BIS a , which tend to be denominated in local currency to a much greater extent than international bond markets, and better disciplined monetary and fiscal policies, which have made both domestic and foreign investors more willing to hold such local-currency-denominated debt.

One can tell a similar story about debt crises in emerging economies. There have been many severe debt problems during the past dozen years Pakistan, Ukraine, Uruguay, Thailand, Indonesia, Ecuador, Russia, and Argentina but not much in the last several years. Debt crises occur when investors conclude that the debt ratio has become unsustainable. The traditional framework for analyzing debt sustainability is to call the debt "sustainable" if the ratio of public or external debt GDP is constant or falling and to label it as "unsustainable" if that ratio is increasing.

To make a projection for what the public debt ratio will be next year, one makes year-ahead projections for the economy's real GDP growth rate, the real interest rate on the debt, and the primary surplus in the government budget. Because analysis of public debt ratios ignores the economy's ability to generate foreign exchange revenues, most analysts supplement the exercise for public debt with an analogous one for external debt-the only difference being that for external debt, the economy's trade surplus replaces the government's primary surplus Goldstein The good news here has been that after rising steadily over the to period, the ratio of public debt to GDP for emerging economies has fallen by roughly 4 percentage points over the period.

According to the IMF , this recent large improvement in the relationship between real GDP growth and the real interest rate on debt was the main factor in turning around the worrisome trend in public debt for emerging economies.

Average overall fiscal deficits of emerging economies have also declined, and there has also been a modest improvement in the average primary surplus. Whereas in or , one could be skeptical about the ability of some emerging economies to deliver a 3 percent or higher primary surplus over an extended period, the fiscal performance of Brazil, Turkey, and some others over the past four years had made it easier to believe that debt ratios can sometimes be reduced significantly without debt restructurings. Developments on the external debt front have been even more favorable.

I. Introduction

While external debt ratios for emerging economies have been falling since the mids, it is noteworthy that relative to exports of goods and services, both external debt and external debt service payments are now less than half as high as they were as recently as IMF b. In addition to the growth and interest rate trends mentioned earlier, will be the eighth year in a row that emerging economies as a group have run current account surpluses.

To sum up, while there are many factors that have contributed to the much improved recent scorecard on emerging-market currency and debt crises-including more buoyant industrial-country growth and easy global credit conditions-an important part of the reduced crisis vulnerability is the progress made by emerging economies in reducing currency mismatches and in improving debt sustainability.

I think that progress also explains in part why emerging economies have at least so far suffered relatively little in the recent bout of financial turbulence initiated by the subprime crisis in the United States. If crisis vulnerability in emerging economies has been going down, can't we go further and foresee soon the end of such crises? I think that such a conclusion would be going too far: Reduced vulnerability does not mean no vulnerability, improvements have not been made evenly across the emerging-market world, and new threats continue to surface.

Let me be more specific about two current concerns. The main concern involves the management of very large capital inflows into emerging Europe.

Primary Surpluses and sustainable Debt Levels in Emerging Market Countries

Both gross and net capital inflows in and are larger than those that went to Asian emerging economies in the run-up to the Asian financial crises IMF a. Still, there are warning signs.

This region also has the largest external gross borrowing requirement; for Hungary, Romania, and Turkey, Deutsche Bank estimates this borrowing requirement at 10 percent or more of GDP in Deutsche Bank Among large emerging economies, Hungary is one of the few to have a larger aggregate currency mismatch in than it had in In , Estonia, Latvia, Albania, and Romania each experienced private sector credit growth of 50 percent or more, and credit growth in Slovenia, the Slovak Republic, and Lithuania topped 20 percent; growth of external financing also rose in by 20 percent or more in Bulgaria, Croatia, Cyprus, Estonia, Hungary, Kazakhstan, Latvia, Romania, Russia, South Africa, and the Ukraine.

External borrowing by banks in Russia and Turkey in was more than five times greater than their external borrowing during the surge World Bank Banking systems in Bulgaria, Hungary, Turkey, Estonia, and the Slovak Republic all get a "D" rating on Fitch's Stand-Alone Bank Soundness ratings, and equity market-based credit risk indicators suggest that default risk in is considerably higher for banks in emerging Europe than for those in either Latin America or emerging Asia IMF c.

Companies from emerging Europe now account for 39 percent of total foreign borrowing by developing-country firms-up from 19 percent in World Bank Some of these banks have increased their foreign exchange exposure to worrisome levels, a concern that warrants special attention from national policymakers. To summarize, we are seeing troubling echoes of some of the key vulnerabilities of the Asian financial crisis now playing out in emerging Europe and in some of its neighbors in the Commonwealth of Independent States CIS.

I am not saying that a financial crisis in emerging Europe is imminent, nor I am denying that vulnerabilities differ significantly across economies in that region. But I am suggesting that if there is a bout of serious risk aversion in international financial markets, the fallout in emerging Europe is not apt to be a pretty one. A second concern is that we could get weaker than expected economic growth in both United States and China in with adverse consequences for emerging economies.

For China, the corresponding consensus forecast is for 11 percent growth in and for 10 percent in In both countries, however, there are plausible scenarios in which growth would fall short of those numbers. In the United States, the most likely culprit for a growth shortfall along with much higher world oil prices would be greater than expected weakness in the housing market, compounded by a correction in the equity market.

The factors contributing to a pessimistic outlook for housing have been laid out recently by Desmond Lachman Lachman of the American Enterprise Institute, with emphasis on, inter alia, the increasing reset rate for adjustable mortgages, the dramatic tightening of mortgage lending standards, the greatly reduced rate of home equity withdrawal, and the forecast from Case-Shiller future house price contracts, suggesting a double-digit decline in housing prices over the next two years. A correction in the equity market-spurred perhaps by lower earnings-is relevant because stock price gains over the past 18 months have so far more than offset the loss in housing wealth on personal-sector net worth.

If US equity prices fell in while the housing decline accelerated, it would be difficult to sustain consumer spending at forecast rates. In China, the long-running rise in the investment share of GDP seems finally to have reached a plateau, yet economic growth has accelerated. The main reason for this outcome is China's mushrooming global trade surplus. Whereas net exports accounted for an average of less than 5 percent of growth in , they accounted for more than a fifth of growth in and probably more than that in Goldstein and Lardy But trees don't grow to the sky.

At some point, the rate of expansion of China's net exports will have to slow-because the domestic and foreign pressures for external adjustment will become irresistible. When that happens-and it could be as early as the contribution of net exports to growth will diminish significantly, domestic demand growth could also slow a little, and China's overall economic growth could decline-perhaps on the order of two to three percentage points.

If economic growth in the United States and China slows at roughly the same time, global growth will get less of a push from two of its main locomotives, and those emerging economies that have either relatively large trade links with them, or relatively high export openness or relatively high dependence on commodity exports, will suffer the most Goldstein Emerging economies in Europe would be much less affected, since they are much more dependent on the European Union as an export destination.

On the primary commodity side and abstracting from major oil exporters in the Middle East, Latin America is the region most vulnerable to a commodity shock. Again, I don't want to suggest that a joint US-China growth slowdown would necessarily initiate a set of emerging-market crises. But it would increase significantly the vulnerability of emerging markets and would make the external environment facing them much less benign than it has been in recent years.

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Jonathan David Ostry Abdul d Abiad. Abdul Abiad Jonathan David Ostry. This paper aims to put some constraints on the way primary surpluses are projected when making assessments of public debt sustainability. Projections should be tied either to the country's historical track record in generating surpluses-if the institutional and other factors accounting for this track record are expected to persist-or to some model that links primary surpluses to their fundamental determinants, either on the basis of constant institutions and policies or a credible reform program.

History-based or model-based primary surplus projections provide a useful benchmark for judging the realism of fiscal forecasts underlying debt sustainability calculations. Together with information on future growth and interest rates, the primary surplus projections can be used to generate measures of overborrowing, and the magnitude of adjustment needed to return debt to a sustainable level. Download full text from publisher File URL: Corrections All material on this site has been provided by the respective publishers and authors.

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