The euro crisis and emerging markets
With the debt crisis worsening, trouble is in store for the neighbours
Nov 12th 2011 | from the print edition.
AS THE rich world lurches from one crisis to the next, a consolation has been that emerging economies, which account for about half of world output, have been growing quickly. Even the wretched euro zone has a few racy emerging markets nearby. Turkey has on occasion rivalled China, with GDP growth of around 9% in 2010. Poland’s was the only economy in the 27-strong European Union to avoid recession in 2009.
Sadly, euro misery seems to love company. A deep recession in the currency zone would leave few countries unscathed, even in fast-growing emerging Asia. For developing economies closer to home, the euro zone’s banks may be the main route by which the suffering spreads.
These banks are under pressure to meet higher capital-ratio targets as part of a deal made last month to “save” the euro. Lenders may choose to cut loans rather than raise equity, which would dilute existing shareholders (including bank executives). Europe’s banks are owed $3.4 trillion by emerging economies, $1.3 trillion of which has been lent to eastern Europe, according to the Bank for International Settlements. Many have subsidiaries in the region. If banks choose to sacrifice foreign lending to concentrate on business at home, it could choke the supply of credit.
The current-account balance is a rough guide to which countries are most vulnerable. On that basis, Asia is generally a safer place than eastern Europe, where several countries run large current-account deficits, and so rely in part on fresh loans from big European lenders. Turkey looks at risk: the IMF puts its deficit at 10% of GDP this year. Poland has a biggish deficit, although Commerzbank’s pledge suggests its credit line to rich Europe may be more solid. Hungary is in surplus but it still has a financing hole to fill, says Gillian Edgeworth of UniCredit, because it has IMF loans to pay off and because foreign banks have been slowly withdrawing from it. Investors have been spooked by the government’s rows with its IMF rescuers and by a plan to cap repayments on Hungarians’ foreign-exchange mortgages. Greece’s banking troubles are a threat to economies in south-east Europe.
A drying up of foreign bank credit would also put downward pressure on the currencies of countries that rely on foreign capital, making it trickier for them to cut interest rates to stimulate their economies. Some emerging markets have already seen their currencies drop in recent months (see chart). A big sell-off in September, since partly reversed, was a warning of future trouble, says Stephen Jen of SLJ Macro Partners, a hedge fund.
There is an irony here. As the euro zone’s trouble spots, such as Italy, struggle against the constraints of a currency union, some developing countries (and a few rich ones, such as Japan and Switzerland) have long grappled with the problem of managing floating exchange rates. Brazil imposed a tax on the flightier sorts of foreign capital to stop the real from appreciating too much. In a similar vein Turkey initiated a range of unorthodox measures late last year to curb capital inflows and relieve the upward pressure on its currency, the lira. To cool a credit boom, the authorities forced banks to hold more cash reserves and put ceilings on property loan-to-value ratios as alternatives to raising interest rates (which might attract yet more footloose money). Turkey’s central bank also intervened in currency markets to hold down the lira.
Now a different set of problems looms. Fearful of inflation, which has risen to 7.7%, in part because of the weaker currency, the bank has recently reversed tack and sold some of its foreign-currency reserves to prop up the lira. Since its reserves are quite modest, Turkey may have to keep interest rates fairly high to defend its currency and maintain external financing, which would increase the chances of a hard landing. A cheaper currency should, in principle, boost exports and curb imports, narrow the current-account deficit and so reduce the amount of fresh borrowing needed from abroad. But the inflation that comes with higher import prices will temper the competitive gain from a cheaper lira; and euro-zone recession will hurt exports.
Europe’s banks are not the only source of foreign capital for Turkey, Poland and the rest. Purchases of bonds and stocks by foreign investors (“portfolio inflows”) are important, too, and have held up surprisingly well, says Ms Edgeworth. Rich-world investors have been keen on exposure to emerging markets because of low yields at home. But weakening currencies would mean losses on such investments, which could slow—or reverse—portfolio flows. That in turn would further depress currencies, reinforcing a vicious cycle.
A few policymakers are alive to the risks. Mr Carney suggested European banks should be required “to meet at least part of their requirements by raising private capital” rather than being able to do so entirely by deleveraging. The IMF is also sounding warnings. Erik Berglof of the European Bank for Reconstruction and Development has called for a second “Vienna Initiative”, a successful 2009 pact to keep bank loans flowing to eastern Europe. But the pressure on the euro-zone is now far greater than it was back then, so the near-abroad is less of a priority.