Emerging market FX-indebtedness: Another war to fight post-COVID?
The economic effect of the global pandemic is proving to be more than just an economic slowdown. As a few countries are gradually opening up and ending quarantines; the demand-deprived economies show little sparks of hope for revival. However, some fragile economies, such as emerging markets, whose economies are sensitive to foreign capital flows are experiencing macroeconomic conundrums. With high amounts of foreign debt and current account deficits; interest rate-exchange rate-inflation triangles are slowly proving to be hardly manageable for some emerging markets.
As the pandemic unfolded and the global economy went through an abrupt demand decline and supply chain distortions, EM central banks faced the harsh decision between providing liquidity via monetary policy moves; or facing further currency depreciation and heightened inflationary pressures during the immediate phase of the pandemic. As investors rush to US dollar for a safe haven, central banks of emerging markets are depleting their foreign currency reserves to fight against local currency depreciation[1]. FED’s swap lines did not prove adequate yet (with some emerging markets not even being on the list). The risk of liquidity crunches continue as a considerable portion of local currency debt is also foreign owned in emerging markets, which are highly vulnerable to capital flight[2]. According to article, more than 60% of all foreign bank reserves and 40% of all debt is held in US dollars[3].
Year-to-date performance of EM currencies against the US dollar. Most emerging markets still experience currency depreciation with central bank reserves dwindling. Data as of May 21st 2020.
Source: EquityRT
Nomura Bank introduced the Damocles Index in September 2018 as an early warning indicator of emerging market exchange rate crises. Latest issue of Nomura Bank’s Damocles Index points to the possibility of a currency crisis in some of the emerging market economies in the next 12 months, namely Ukraine, Sri Lanka, Pakistan and Turkey, whose currencies depreciated year-to-date by, respectively, 11%, 3.9%, 3.6% and 12.5%. All these countries also have current account deficits, with Ukraine 3.34% (2018), Sri Lanka 2.64% (2017), Turkey 3.53% (2018) and Pakistan 5.58% (2017) as percentage of GDP[4].
The Damocles Index is made up of five single indicators and 3 joint indicators, and a score above 100 suggests a country is vulnerable to a currency crisis in the next 12 months. The indicators are 1) import cover, 2) short-term external debt/exports, 3) FX reserves/short-term external debt, 4) broad money/FX reserves; and 5) real short-term interest rates (the three joint indicators are 1) non-FDI gross inflows, 2) fiscal and current accounts; and 3) current account and real effective exchange rate deviation) [5]. Last issue of the Index reports four countries above this threshold: Ukraine (138), Sri Lanka (110), Pakistan (104) and Turkey (104). Only the Philippines, India, Bulgaria, Peru, Russia and Thailand got a Damocles score of zero, signaling “very low risk” of a currency crash[6].
Data compiled from IMF and the World Bank on these four countries reveal high external debt levels, both total debt and short-term debt denominated in foreign currencies at significant percentages, exports not covering imports (with the exception of Turkey at 1.09x), below 100% FX reserves coverage for short term external debt (with the exception of Ukraine), relatively low coverage of exports over short term external debt (Turkey having the highest coverage with 50%), most short-term external debt being denominated in foreign currency (with above 90% levels for Sri Lanka and Ukraine), high short-term debt levels as percentage of GDP (with 12% and 16% for Sri Lanka and Turkey respectively).
Similar emerging markets that have high amounts of dollar-denominated foreign debt and already wide current account deficits face heightened inflationary pressures or declining currencies due to the capital outflows and increased demand for safe havens. Soaring interest payments on short-term external foreign debt already squeeze these economies’ ability to serve immediately due debt service. As a result, both major central banks of the globe, as well as multilateral organization have been looking for ways to restore confidence in riskier assets. IMF approved large amounts of possible lending, development finance institutions have approved massive amounts of financing in loans and grants for the public and private sectors, and multilaterals are asking bilateral lenders, such as China, to halt debt payments from 76 low-income countries[11].
Central banks of those economies with already high inflationary environments may not have too much room for monetary policy maneuvers, in fact some emerging markets may have become insensitive to rate cuts in terms of intended credit growth. On the other hand, governments who are unable to either stimulate their economies via monetary policy actions, or bail out large corporations may end up needing international support; or increasing number of defaults, unemployment and people’s inevitable reliance on more state support to get through a potentially prolonging economic crisis to follow.
Sources Used:
[1] Bloomberg. Emerging Currencies Under Threat from Covid-19 Face Further Declines. April 6, 2020.
[2] Marcus Ashworth. Business Times. Emerging markets peering over precipice as financial fallout from Covid-19 spreads. April 11, 2020.
[3] Al Jazeera. Pandemic proves there is only one world reserve currency. 28 March 2020.
[4] International Monetary Fund. https://data.imf.org/regular.aspx?key=60961514. Accessed May 22, 2020.
[5] Nomura Bank. Damocles: our early warning indicator of exchange rate crises. September 2018.
[6] Ian Nicolas Cigaral. PhilStar Global. Peso immune to coronavirus-induced currency crash — Nomura. April 17, 2020.
[7] The World Bank, GDP (Current US$). Accessed May 22, 2020.
[8] International Monetary Fund. Balance of Payment Statistics. Accessed May 22, 2020.
[9] The World Bank. Table C5 — Gross External Debt Position Foreign Currency and Domestic Currency Debt (USD millions). Accessed May 22, 2020.
[10] The World Bank International Debt Statistics. Accessed May 22, 2020.
[11] Paulina Restrepo-Echavarria. COVID-19’s Economic Effects on Poor and Emerging Markets. April 6, 2020.
