Category Archives: Emerging Markets

Will A Rise in Interest Rates Lead to a New Debt Crisis?

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The question of when the Federal Reserve will begin to reverse its loose policy stance continues to be a topic of widespread speculation. At last month’s meeting of the Federal Open Market Committee, its members showed a willingness to cut back on asset purchases in 2022 and to raise interest rates in 2023, but kept monetary policy on its current setting due to slower growth in employment than desired. The latest inflation reading may bring forward the Fed’s tightening measures. If and when interest rates do rise in the U.S. and other advaneced economies, what will be the impact for holders of foreign assets?

There is a split in opinions on the vulnerability of emerging market economies (EMEs) to rising interest rates. In an interview with Finance & Development, Richard House of Allianz Global Investors and David Lubin of Citibank played down the chances of a disruption of foreign markets when the Federal Reserve begins its reversal. They cite the increase in foreign exchange reserves and the decrease in the number of countries with fixed exchange rates as reasons why systemic crises can be avoided. In the same issue, however, Şebnem Kalemli-Özcan of the University of Maryland points out that country-dependent risk will affect the response to a new external environment. Many EMEs used monetary policy to finance their fiscal spending in response to the pandemic. There is a concern that their bond purchases and monetary creation could lead to higher inflation that will raise the cost of new financing at the same time as the U.S. is raising its interest rates.  

The author of the Buttonwood column of The Economist, however, notes that the central banks in several EMEs have already raised their policy rates in response to concerns of rising inflation following currency depreciations. Higher rates attract capital from foreign investors looking for higher yields, which strengthens the currency. An appreciating currency keeps down import prices and inflation in check.

Jasper Hoek and Emre Yoldas of the Federal Reserve Board and Steve Kamin of the American Enterprise Institute show that the response of emerging market economies to rising U.S. interest rates will depend in part on the reasons for the increase. If rates rise because of favorable economic growth in the U.S., then the EMEs should benefit from the increase in U.S. demand for their goods and increased investor confidence. If, on the other hand, the higher rates are due to higher inflation that requires a marked tightening of the U.S. policy stance, then interest rates on the debt of EME issuers will rise as their currencies fall in value.

The response to the pandemic in the EMEs is the biggest challenge those nations face.  While firms in the U.S. and Europe are busy meeting surging consumer demand, the virus continues to spread in Africa, South American and South Asia. The response in advanced economies to a recovery that brings with it higher inflation may threaten the ability of the EMEs’ policymakers to maintain their accommodative stance. Agustín Carstens, General Manager of the Bank for International Settlements, warns: “… it could be hard for EME policymakers to maintain accommodative policy stances should global financial conditions tighten materially. But tighter policy will make economic recovery even more difficult.”

The record of responses to Federal Reserve policy retrenchment is not encouraging. In May 2013, then Fed Chair Ben Bernanke responded to a question at a Congressional committee meeting about future Fed policy by noting that “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases.” This innocuous remark led to turbulence in the financial markets, which became known as the “taper tantrum.” Increases in the Federal Funds Rate in 2018 under Fed Chair Jerome Powell met widespread criticism and concerns about their impact on slow economic growth, and the Federal Reserve reversed course in 2019.

Economists can always provide well-reasoned narratives as to how and why financial markets respond to events. Unfortunately, market volatility is almost always unanticipated. No matter how careful policymakers are with their statements, there is the potential for an unforeseen response. The continuation of the pandemic heightens the uncertainty, and the current elevated levels of stock prices and the increase in debt leaves asset markets vulnerable to a “Minsky moment” when an initial reversal leads to a demand for liquidity and cascading falls in financial markets. The EMEs will become part of the collateral damage of such a collapse.

“The Sources of International Investment Income in Emerging Market Economies”

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The Review of International Economics has published my paper on “The Sources of International Investment Income in Emerging Market Economies” in its latest issue. You can find the paper here, and this is the abstract:

We investigate international investment income flows in 26 emerging market countries during the period of 1998–2015. Net investment income registered a deficit for this group of countries of between 2% and 3% of GDP during this period. This deficit has been dominated by payments on foreign direct investment liabilities, which is consistent with the change in the composition of the external liabilities of these countries. Our results indicate that both capital account and trade openness are associated with the deficits on direct investment income. In addition, there was a small deficit in portfolio investment income, which is affected by the development of domestic financial markets and investor protection. Other investments’ income and the income from foreign exchange reserves have a negligible role in total investment income.

Recent Research

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My recent research has dealt with issues related to financial globalization, and the accumulation of foreign assets and liabilities on external balance sheets. These include equity (foreign direct investment and stock) and debt (bonds and bank loans). Their amounts and composition differ between the emerging market economies and the advanced economies. The former generally hold assets in the form of foreign reserves, and issue equity to finance domestic investment. The latter nations hold the equity of the emerging economies and sell debt. In my work I have investigated the impact of the composition of the external balance sheets on economic performance as well as the determinants of the equity/debt liabilities mix, and this work has now been published.

In “External Liabilities, Domestic Institutions and Banking Crises in Developing Economies” (working paper here), my coauthors, Nabila Boukef Jlassi of the Paris School of Business and Helmi Hamdi of CERGAM EA 4225 Aix-Marseille University, and I examined the impact of foreign equity and debt liabilities on the occurrence of bank crises in 61 lower- and middle-income counties during the period of 1986-2010. We found that FDI liabilities lowered the probability of such crises while debt liabilities increased it. However, we also found that domestic institutions that decreased financial or political risk partially offset the impact of the debt liabilities on the probability of bank crises. A decrease in investment risk directly reduces the incidence of crises.

In “External Balance Sheets as Countercyclical Crisis Buffers” (working paper here), I investigated the claim that the composition of the external balance sheets of many emerging markets—“long debt and foreign exchange, short equity”—affected the performance of these countries during the global financial crisis of 2008-09. Using data from 67 emerging market economies, I showed that those economies that had issued FDI liabilities had higher growth rates during the crisis, fewer bank crises and were less likely to borrow from the IMF. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit.

Why do equity—and FDI in particular—and debt have such different impacts? First, equity represents a sharing of risk, whereas debt is a contractual commitment by the borrower. The equity premium is a compensation for the lower return incurred during a downturn. Second, debt is more likely to be reversed during a crisis than FDI, contributing to a “sudden stop.”. Third, FDI investors may be willing to provide more finance to keep their investment viable during a period of financial stress.

What determines the equity/debt mix of liabilities? In “Partners, Not Debtors: The External Liabilities of Emerging Market Economies” (working paper here), I studied the determinants of equity and debt liabilities on the balance sheets of 21 emerging market economies and 20 advanced economies over the period of 1981-2013. In the analysis I used a measure of domestic financial development that distinguished between financial institutions and financial markets. The results showed that the development of domestic financial markets is linked to an increase in equity liabilities, and in particular, portfolio equity. FDI liabilities, on the other hand, are more common when financial institutions are not well developed. Moreover, countries with higher growth rates are more likely to issue equity. Larger foreign exchange reserves are also associated with more portfolio equity.

The composition of assets and liabilities has other effects. Changes in the their values will impact a country’s net international investment position, which influences domestic spending and international solvency. In addition, they yield different income streams that determine net investment income, a component of the current account. In my current work I am looking at the income investment flows of advanced and emerging market countries. The flows in the advanced economies grew rapidly during the period of financial globalization leading up to the global crisis of 2008-09. In some cases, such as Japan and the United Kingdom, the net flows have become substantial and are a major determinant of the current account. The income flows of the emerging market economies did not have the same rapid growth, but their composition changed from payments to banks to payments on FDI and portfolio equity. I plan to write about these changes in future research papers.

 

Venezuela and the Next Debt Crisis

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The markets for the bonds of emerging markets have been rattled by developments in Venezuela. On November 13,Standard & Poor’s declared Venezuela to be in default after that country missed interest payments of $200 million on two government bonds. Venezuelan President Nicolás Maduro had pledged to restructure and refinance his country’s $60 billion debt, but there were no concrete proposals offered at a meeting with bondholders. By the end of the week, however, support from Russia and China had allowed the country to make the late payments.

Whether or not Venezuela’s situation can be resolved, the outlook for the sovereign debt of emerging markets and developing economies is worrisome. The incentive to purchase the debt is clear: their recent yields of about 5% and total returns of over 10% have surpassed the returns on similar debt in the advanced economies. The security of those returns seem to be based on strong fundamental condtions: the IMF in its most recent World Economic Outlook has forecast growth rates for emerging market and developing economies of 4.6% in 2017, 4.9% next year and 5% over the medium term.

The Quarterly Review of the Bank for International Settlements last September reviewed the government debt of 23 emerging markets, worth $11.7 trillion. The BIS economists found that much of this debt was denominated in the domestic currency, had maturities comparable to those of the advanced economies, and carried fixed rates. These trends, the BIS economists reported, “..should help strengthen public finance sustainability by reducing currency mismatches and rollover risks.”

It was not surprising, then when earlier this year the Institute for International Finance announced that total debt in developing countries had risen by $3 trillion in the first quarter. But surging markets invariably attract borrowers with less promising prospects. A FT article reported more recent data from Dealogic, which tracks developments in these markets, that shows that governments with junk-bond ratings raised $75 billion in syndicated bonds this calendar year. These bonds represented 40% of the new debt issued in emerging markets. Examples of such debt include the $3 billion bond issue of Bahrain, Tajikistan’s $500 million issue and the $3 billion raised by Ukraine. These bonds offer even higher yields, in part to compensate bondholders for their relative illiquidity.

The prospects for many of these economies are not as promising as the IMF’s aggregate forecast indicates. The IMF’s analysis also pointed out that there is considerable variation in performance across the emerging market and developing economies. The projected high growth forecast for the next several years is based in large part on anticipated growth in India and China, which account for more than 40% of the collective GDP of these nations. Weaker growth is anticipated in Latin America and the Caribbean, sub-Saharan Africa, North Africa and the Middle East.

The IMF also raised concerns about the sustainability of the sovereign debt of these countries in October’s Global Financial Stability Report. In the case of low-income countries, the report’s authors warned: “…this borrowing has been accompanied by an underlying deterioration in debt burdens… Indeed, annual principal and interest repayments (as a percent of GDP or international reserves) have risen above levels observed in regular emerging market economy borrowers.” Similarly, Patrick Njoroge, head of Kenya’s central bank, has warned that some African nations have reached a debt-servicing threshold beyond which they should not borrow.

None of these developments will surprise anyone familiar with the Minsky-Kindleberger model of financial crises. This account of the dynamics of such crises begins with an initial change in the economic environment—called a “displacement”—that changes the outlook for some sector (or nation). The prospect of profitable returns attracts investors. Credit is channelled by banks to the new sector, and the increase in funds may be reinforced by capital inflows.The demand for financial assets increases their prices. There is a search for new investments as the original investors take profits from their initial positions while new investors, regretful at missing earlier opportunities, join the speculative surge. The pursuit of yield is met by the issuance of new, increasingly risky assets. The “speculative chase” further feeds a price bubble, which is always justified by claims of strong fundamentals.

At some point there is a reassessment of market conditions. This may be precipitated by a specific event, such as a leveling off of asset prices or a rise in the cost of funding. An initial wave of bankruptcies or defaults leads to the exit of some investors and price declines. Further selling and the revelation of the flimsy undergirding of the speculative bubble results in what Kindleberger calls “revulsion.” In a world of global financial flows there are “sudden stops” as foreign investors pull out their funds, putting pressure on fixed exchange rates. Contagion may carry the revulsion across national boundaries. The end, Kindleberger wrote, comes either when prices fall so low that investors are drawn back; or transactions are shut down; or when a lender of last resort convinces the market that sufficient liquidity will be provided.

The market for the bonds of developing economies has followed this script. The initial displacement was the improvement in the growth prospects of many emerging market countries at a time when the returns on fixed investments in the advanced economies were relatively low. A credible case could be made that emerging market economies had learned the lessons of the past and had structured their debt appropriately. But the subsequent increase in bond offerings by governments with below investment grade ratings shows that foreign investors in their eagerness to enter these markets were willing to overlook more risky circumstances. This leaves them and the governments that issued the bonds vulnerable to shocks in the global financial system. A rise in risk aversion or U.S. interest rates would lead to rapid reassessments of the safety and sustainability of much of this debt.

This potential crisis has caught the attention of those who would be responsible for dealing with its painful termination. The IMF’s Managing Director Christine Lagarde at the Fund’s recent annual fall meeting warned of the risk of “a tightening of the financial markets and the potential capital outflows from emerging market economies or from low‑income countries where there has been such a search for yield in the last few years.” The IMF has dealt with this type of calamity before, and it never ends well.

The Emerging Market Economies and the Appreciating Dollar

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U.S. policymakers are changing gears. First, the Federal Reserve has signaled its intent to raise its policy rate several times this year. Second, some Congressional policymakers are working on a border tax plan that would adversely impact imports. Third, the White House has announced that it intends to spend $1 trillion on infrastructure projects. How all these measures affect the U.S. economy will depends in large part on the timing of the interest rate rises and the final details of the fiscal policy measures. But they will have consequences outside our borders, particularly for the emerging market economies.

Forecasts for growth in the emerging markets and developing economies have generally improved. In January the IMF revised its global outlook for the emerging markets and developing economies (EMDE):

EMDE growth is currently estimated at 4.1 percent in 2016, and is projected to reach 4.5 percent for 2017, around 0.1 percentage point weaker than the October forecast. A further pickup in growth to 4.8 percent is projected for 2018.

The improvement is based in part on the stabilization of commodity prices, as well as the spillover of steady growth in the U.S. and the European Union. But the U.S. policy initiatives could upend these predications. A tax on imports or any trade restrictions would deter trade flows. Moreover, those policies combined with higher interest rates are almost guaranteed to appreciate the dollar. How would a more expensive dollar affect the emerging markets?

On the one hand, an appreciation of the dollar would help countries that export to the U.S. But the cost of servicing dollar-denominated debt would increase while U.S. interest rates were rising. The Bank for International Settlements has estimated that emerging market non-bank borrowers have accumulated about $3.6 trillion in such debt, so the amounts are considerable.

In addition, Valentina Bruno and Hyun Song Shin of the BIS have examined (working paper here) a “risk-taking” channel of U.S. monetary policy that links exchange rate movements to cross-border banking flows. In the case of an appreciation of a foreign currency, domestic banks in the affected countries channel funds from global banks to firms with local currency assets that have risen in value. A domestic currency depreciation in response to U.S. monetary policy will lead to a contraction in such lending.

Jonathan Kearns and Nikhil Patel of the BIS have sought to determine whether the “financial channel” of exchange rates offsets the “trade channel.” The sample of countries they use in their empirical analysis includes 22 advanced economies and 22 emerging market economies, and the data for most of these countries begins in the mid-1990s and extends through the third quarter of 2016. They use two exchange rate indexes, where the indexes measures the foreign exchange values of the domestic currency, in one case weighted by trade flows and the second by foreign currency-denominated debt.

Their results provide evidence for both channels that is consistent with expectations: the trade-weighted index has a negative elasticity, while the debt-weighted index has a positive linkage. For 13 of the 22 emerging market economies, the sum of the two elasticities is positive, indicating than an equal appreciation of the domestic currency would be expansionary. The financial channel is stronger for those emerging market economies with more foreign currency debt.

Does this indicate that further appreciation of the dollar will lead to the long-anticipated debt crisis in the emerging markets? When Kearns and Patel replaced the debt-weighted exchange rate index with the bilateral dollar rate, they found that the debt-weighted index does a better job in capturing the financial channel than the dollar exchange rate alone. The other foreign currencies in the debt-weighted index included the euro, the yen, the pound and the Swiss franc, so a rise in the dollar is not as important when the debt is denominated in the other currencies.

Domestic policymakers in the emerging market countries seem to have done a good job in restraining domestic credit growth, which is often the precursor of financial crises. There is one significant exception: China. One recent estimate of its debt/GDP ratio placed that figure at 277% at the end of 2016. The government is attempting to slow this expansion down without destabilizing the economy, which now has a growth target of 6.5%. What happens if the dollar appreciates against the renminbi as it did last year, when China used up a trillion dollars in foreign exchange reserves in an attempt to slow the loss in value of its currency? About half of China’s external debt is denominated in its own currency, so it has less to fear on this score than do other borrowers.

A team of IMF economists that included Julian Chow, Florence Jaumotte, Seok Gil Park, and Yuanyan Sophia Zhang examined in 2015 the spillovers from a dollar appreciation. They noted that many emerging market economies are currently less vulnerable to a dollar appreciation than they were during previous periods. However, they also reported that some countries in eastern Europe and the Commonwealth of Independent States have short positions in dollar-denominated debt instruments. They investigated corporate borrowing, including debt denominated in foreign currencies, and performed a stress test analysis based on higher borrowing costs, a decline in earnings and an exchange rate depreciation to see which countries had the most vulnerable firms. They reported that increases in foreign exchange exposure would be largest in Brazil, Chile, India, Indonesia and Malaysia. They concluded their report: “Should a combination of severe macroeconomic shocks affect the nonfinancial sector, debt at risk would further rise, putting pressure on banking systems’ buffers, especially in countries where corporate and banking sectors are already weak. “

Another team of Fund economists, led by Selim Elekdag, also investigated rising corporate borrowing in the emerging market economies in the October 2015 Global Financial Stability Report. They attributed the rise in corporate debt in these countries to accommodative global monetary conditions. Consequently, these firms are quite vulnerable to changes in U.S. interest rates.

Some analysts see signs of a “virtuous cycle” in many emerging market economies. The motivating factors range from pro-growth policies in India to China’s ability (to date) to avoid a severe slowdown. But these economies are quite vulnerable to external developments. The Federal Reserve recognize this, and takes the foreign impact of its policies into account. But no such assurance comes from the rest of the U.S. government. President Trump’s fulfillment of his promise to disrupt the normal policy process in Washington will have a broad impact outside the U.S. as well.

Capital Flows and Financial Activity in Commodity Exporters

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Emerging markets and developing economies have struggled in recent years to regain the growth rates of the last decade before the global financial crisis. The slowdown has been particularly evident in commodity-exporters that face declining prices. The World Bank’s most recent Global Economic Prospects, for example, projects growth for those countries of only 0.4% in 2016. Moreover, the fall in commodity prices is linked to capital flows to those countries and an increase in the fragility of their financial sectors.

In a recent paper in the Journal of International Money and Finance, Joseph P. Byrne of Heriot-Watt University and Norbert Fiess of the World Bank examined the determinants of capital inflows to 64 emerging market economies. Among the drivers of capital flows were real commodity prices: an increase in these prices increased flows to the emerging markets, particularly total equity and bank flows. Real commodity prices also contributed to an increase in the global volatility of capital flows.

Commodity price cycles, therefore, should be associated with capital flow cycles, and declines in both may lead to financial crises. Carmen Reinhart of Harvard’s Kennedy School, Vincent Reinhart of the American Enterprise Institute and Christoph Trebesch of the University of Munich documented such a correspondence of capital flows, commodity prices and sovereign defaults during the period 1815 to 2015 in a paper in the American Economic Review Papers and Proceedings 
(working paper here). They found evidence of an overlap between booms in capital flows and commodity prices, which resulted in a “double bonanza,” and a “double bust” when capital flows and prices declined. They also recorded the incidence of sovereign defaults, and found that four of six global peaks in defaults followed double busts in capital flows and commodity markets. The most recent boom was exceptionally prolonged, beginning in 1999 and lasting until 2011, and was followed by a “double bust.”

Commodity prices can also affect the fragility of domestic financial sectors. Tidiane Kinda, Montfort Mlachila and Rasmané Ouedraogo in an IMF working paper looked at the impact of commodity price shocks on the financial sectors in 71 emerging market and developing economies that are commodity exporters. Falling prices weakened the financial sector as manifested through higher non-performing loans and reduced bank profits, and an increased probability of a banking crisis. The transmission channels included an increase in the amount of debt denominated in foreign currency as well as lower economic growth and less government revenues.

The fragility of the financial sectors of the commodity exporters has been exacerbated by a growth in private credit. The World Bank’s Global Economic Prospects has reported that credit to the nonfinancial sector in emerging markets and developing economies increased in the five years ending in 2015, and credit growth was particularly pronounced in commodity exporting countries. Much of this credit went to nonfinancial corporations, and the borrowing was concentrated in the energy sector. As a result, credit growth in the commodity exporting emerging market and developing economies has risen to levels of credit/GDP that in the past have been associated with credit booms that have often (but not always) been followed by bank crises.

Commodity price fluctuations, therefore, are accompanied by changes in capital flows and the status of financial sectors in commodity exporters. Booms in domestic credit can further threaten long-term financial stability. More flexible exchange rates may alleviate some of the strain of a downturn in commodity prices and capital inflows. But countries such as Brazil, Indonesia and Russia face little relief from the drag on their economic performance as long as commodity prices remain depressed. The accommodative monetary policies of the advanced economies have bolstered asset prices in many emerging markets, but that situation can not be counted on to continue indefinitely.

Growth in the Emerging Market Economies

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In recent decades the global economy has been transformed by the rise of the emerging market economies. Their growth lifted millions out of poverty and gave their governments the right to call for a larger voice in discussions of international economic governance. Therefore it is of no small importance to understand whether recent declines in the growth rates of these countries is a cyclical phenomenon or a longer-lasting transition to a new, slower state. That such a slowdown has wide ramifications became clear when Federal Reserve Chair Janet Yellen cited concerns about growth in emerging markets for the delay in raising the Fed’s interest rate target in September.

The data show the gap between the record of the advanced economies and that of the emerging markets. I used the IMF’s World Economic Outlook database to calculate averages of annual growth rates of constant GDP for the two groups.

2001-07 2008-09 2010-15
Advanced 2.46% -1.62% 1.82%
Emerging and Developing 6.62%  4.48% 5.47%
Difference: (Emerging + Developing)               – Advanced 4.16%  6.1% 3.65%

The difference in the average growth rates was notable before the global financial crisis, and rose during the crisis. Since then their growth rates have fallen a bit but continue to exceed those of the sclerotic advanced economies. Since the IMF pools emerging market economies with developing economies, the differences would be higher if we looked only at the record of emerging markets such as China, India and Indonesia.

And yet: behind the averages are disquieting declines in growth rates, if not actual contractions, for some members of the BRICS as well as other emerging markets. The IMF forecasts a fall in economic activity for Brazil of -3.03% for 2015 and for Russia of -3.83%, which makes South Africa ’s projected rise of 1.4% look vigorous. Even China’s anticipated 6.81% rise is lower than its extraordinary growth rates of previous years, and exceeded by India’s projected growth of 7.26%. The IMF sees economic growth for the current year for the emerging markets and developing economies of 4% , a decline from last year’s 4.6%.

What accounts for the falloff, and can it be reversed? The change in China’s economic orientation from an economy driven by investment and export expenditures to one based on consumption spending has slowed that country down. The decline in that country’s demand for raw materials to transform into finished goods for export is rippling through the economies of the major commodity exporters, such as Australia and Brazil. The Economist has claimed that the resulting fall in commodity prices constitutes a “great bear market.”

This downturn may be aggravated by a failure in institutions. Bill Emmott writes that emerging markets need political institutions that “…mediate smoothly between competing interest groups and power blocs in order to permit a broader public interest to prevail.” He specifically cites the leaderships of Brazil, Indonesia, Turkey and South Africa as examples of governments that have not been able to achieve that task.

The basic model of economic growth, the Solow-Swan model, predicts that income in the poorer countries should catch up with those of the advanced economies as the former countries adopt the advanced technology of the latter. This basic result is modified if there are higher population growth rates or lower savings levels, which can lead to lower per capita income levels. On the other hand, the Asian countries used high savings rates to speed up their economic growth while their birth rates fell.

But convergence has not been achieved for most economies despite periods of rapid growth. Some economists have postulated the existence of “middle-income traps.” Maria A. Arias and Yi Wen of the St. Louis Federal Reserve Bank describe this phenomenon in a recent issue of the institution’s publication, The Regional Economist. They explain that while income rose close to U.S. levels in the “Asian Tigers” (Hong Kong, Singapore, South Korea and Taiwan) as well as Ireland and Spain, per-capita income shows no sign of rising in Latin American economies such as Brazil and Mexico. There may also be a “low-income” trap for developing economies that never break out of their much lower per-capita income.

Why the inability to raise living standards? Arias and Wen, after discussing several proposed reasons such as poor institutions, compare the cases of Ireland and Mexico. They claim that the Irish government opened the economy up to global markets slowly in earlier decades, and encouraged foreign direct investment to grow its manufacturing sector. This allowed the country to benefit from the technology embedded in capital goods. Mexico, on the other hand, turned to foreign capital markets to finance government debt, which left the economy vulnerable to currency crises and capital flight. Arias and Wen conclude that governments should manage the composition of capital inflows and control capital flows that seek short-term gain rather development of the manufacturing sector.

But there may be a more basic phenomenon taking place. In 2013 Lant Pritchett and Lawrence Summers of Harvard presented a paper with the intriguing title, “Asiaphoria Meets Regression to the Mean.” They examined growth rates for a large number of countries for10 and 20 year periods, extending back to the 1950s. They showed that there is ”…very little persistence in country growth rate differences over time, and consequently, current growth has very little predictive power for future growth.” While acknowledging China and India’s achievements, they cautioned that “…the typical degree of regression to the mean imply substantial slowdowns in China and India relative even to the currently more cautious and less bullish forecasts.” They drew particular attention to the lack of strong institutions in the two countries.

If growth does slow for most emerging market economies, then the recent buildup of corporate debt in those countries may be a troubling legacy of the recent, more robust period. Debt loads that looked manageable when borrowing costs were low and future prospects unlimited are less controllable when that scenario changes. While there may not be a widespread crisis that afflicts all the emerging markets, those countries with extended financial sectors are vulnerable to international volatility.

The External Debt of the Emerging Market Economies

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The outflow of money from emerging markets this year will most likely surpass inflows for the first time since 2008, and net capital outflows may total $541 billion according to the Institute of International Finance. The flows have been accompanied by currency depreciations, stock market collapses, and in the case of Brazil, a downgrade in its credit rating to junk bond status. The IMF has responded to this turbulence by lowering its forecast for growth in the emerging markets and developing economies this year from 4.2% to 4%.

The emerging market nations that export commodities have been particularly hard hit, as China cuts back on its imports of raw materials and commodity prices plunge. Other factors that could signal further weakness are declining foreign exchange reserves, current account deficits and political uncertainty. Countries besides Brazil that have been identified as most vulnerable to further downturns include Russia, Venezuela, Turkey and Indonesia. When the long-awaited increase in U.S. interest rates finally does take place, the rise in the cost of borrowing in dollars will exacerbate the position of these countries.

There is another factor that will affect how an external shock will affect economic performance: the composition of a country’s external balance sheet. This records the holdings of foreign assets held by domestic residents and domestic liabilities held by foreigners. A country’s net international investment position (NIIP) as a creditor or debtor depends on the difference between its assets and liabilities. Both assets and liabilities can take the form of equity, which includes foreign direct investment (FDI) and portfolio equity, or debt in the form of bonds and bank loans. In addition, countries may hold assets in the form of foreign exchange reserves at their central banks.

Assets are denominated in foreign currencies, particularly the dollar, while equity liabilities are denominated in the home currency. Debt liabilities may be denominated in the domestic or a foreign currency. Foreign lenders who are concerned about the government’s macroeconomic policies—a phenomenon known as “original sin”—may insist that bonds be issued in dollars.

After the financial crises that afflicted many emerging markets during the late 1990s and early 2000s, many of these nations altered the composition of their external balance sheets. Countries that had obtained external funds primarily through debt turned to equity for sources of finance. As a result, their equity liabilities grew steadily, both in terms of absolute magnitude and relative to their debt liabilities. Their assets, on the other hand, largely consisted of foreign exchange reserves, held in the form of U.S. Treasury bonds, and other debt holdings. This profile is known as “long debt, short equity,” and differed from the “long equity, short debt” composition of most advanced economies that held equity and issued debt.

The payout on equity is contingent on the profitability of the firms that issue it, while debt payments are contractual. As a result, over time equity carries a higher return than debt—the “equity premium.” Consequently, the “long equity, short debt” profile in normal times is profitable for those countries that are net holders of equity.

But the situation changes during a crisis. The decline in the value of equity liabilities raises the NIIP of the countries that issued them. In addition, a depreciation of the domestic currency increases the value of the foreign assets while lowering those liabilities denominated in the domestic currency. Bonds issued in a foreign currency, however, will rise in value—a phenomenon observed during the Asian crisis of 1997-98. In addition, short-term liabilities may not be rolled over by foreign lenders, while FDI is much more stable.

Phillip Lane of Trinity College (working paper here) has claimed that the composition of the emerging market economies’ external balance sheets served as a buffer against the global financial crisis (GFC) of 2007-09, while the structure of the advanced economies’ external assets and liabilities heightened their vulnerability. In a recent paper I investigated this claim and found that countries with FDI liabilities had higher growth rates, fewer bank crises and were less likely to borrow from the IMF during the GFC. Countries with debt liabilities, on the other hand, had more bank crises and were more likely to use IMF credit. The “long debt, short equity” strategy of emerging markets did mitigate the effects of the global financial crisis, and acted as a countercyclical crisis buffer.

But the balance sheet profiles of the emerging market economies has changed in the wake of the crisis. The corporate debt of nonfinancial firms in many emerging market economies, particularly bonds denominated in dollars, grew rapidly during this period. The IMF in its latest Global Financial Stability Report has drawn attention to this shift, which it reports has been driven by global drivers, such as the decline in U.S. interest rates.

A newly-issue report by the Committee on International Economic Policy, Corporate Debt in Emerging Economies: A Threat to Financial Stability?, views this increase in debt as a threat to financial stability. The report, written by Viral Acharya of New York University, Stephen Cecchetti of Brandeis University, José De Gregorio of the University of Chile, Sebnem Kalemli-Ozcan of the University of Maryland, Philip Lane of Trinity and Ugo Panizza of the Graduate Institute in Geneva, reviews the changes in the balance sheets of the emerging markets. They find that “…there has been a deterioration in the net foreign debt positions of many emerging economies in recent years.” While the amounts of corporate debt are limited, the authors point out, “…even a category that appears relatively small can be a source of systemic financial stability.” Moreover, bonds denominated in a foreign currency have accounted for a large component of the growth in corporate debt, and there has been “…an overall decline in the net foreign currency position of many emerging economies.” As a result, “…this has made emerging economies vulnerable to a shift in international funding conditions and macroeconomic slowdown.”

Moreover, the amount of emerging market debt may be underestimated. Carmen Reinhart of Harvard’s Kennedy School points out that debt may go undetected until the outbreak of a crisis. She points to the Mexican crisis of 1995-95, the Asian debt crisis of 1997-98 and the current Greek crisis as examples of the detection of “hidden debt” that became visible as the crisis emerged. She fears that lending by Chinese development banks for infrastructure projects in other emerging and developing economies may not be included in the data for their external debt, and could add to their vulnerability.

The authors of the report on corporate debt in emerging economies point out that policymakers have a variety of policy tools to deal with the risks of external borrowing. These include capital and liquidity regulations, directly lending to small and medium-sized enterprises when banks are constrained by exposure limits, and central clearing of derivative contracts. But all this will come after the deterioration to the external balance sheets has taken place. Governments should monitor the external borrowing of domestic firms and public agencies during “boom” periods to track their vulnerability to shocks to global liquidity. Meanwhile, the IMF is preparing for the next crisis.

Global Volatility, Domestic Markets

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Unlike the global financial crisis of 2008-09, the current disruption in the financial markets of emerging market nations was anticipated. The “taper tantrum” of 2013 revealed the precarious position of many of these nations, particularly those dependent on commodity exports. The combination of a slowdown in Chinese growth, collapsing stock prices and a change in the Chinese central bank’s exchange rate policy indicated that the world’s second-largest economy has its own set of problems. But global volatility itself can roil financial markets, and good fundamentals may be of little help for a government trying to shelter its economy from the instability in world markets.

The importance of global (or “push”) factors for capital flows to emerging markets was studied by Eugenio Cerutti, Stijn Claessens and Damien Puy of the IMF. They looked at capital flows to 34 emerging markets during the period of 2001-2013, and found that global factors such as the VIX, a measure of anticipated volatility in the U.S. stock market, accounted for much of the variation in flows. Not all forms of capital were equally affected: bank-related and portfolio flows (bonds and equity) were strongly influenced by the global factors, but foreign direct investment was not.

Cerutti, Claessens and Puy also investigated whether the emerging markets could insulate themselves from the global environment with good domestic macro fundamentals. They reported that the sensitivity of emerging markets to the external factors depended in large part upon the identity of a country’s investors. The presence of global investors, such as international mutual funds in the case of portfolio flows and global banks in the case of bank finance, drove up the response to the global environment. The authors concluded: “…there is no robust evidence that “good” macroeconomic (e.g., public debt, growth) or institutional fundamentals (e.g., Investment Climate and Rule of Law) have a role in explaining EM different sensitivities to global push factors.”

A similar finding was reported in a study of corporate bond markets in emerging markets, which have grown considerably since the 2007-09 crisis. Diana Ayala, Milan Nedeljkovic and Christian Saborowski, also of the IMF, studied the share of bond finance in total corporate debt in 47 emerging market economies over the period of 2000-13. Domestic factors contributed to the development of bond markets. But the growth in these markets in the post-crisis period was driven by global factors, such as the spread in U.S. high yield bonds, a proxy for global risk aversion, and U.S. broker-dealer leverage. The authors conjecture that the growth in bond finance in the emerging markets was due to a search for higher yields than those available in advanced economies during this period. If this interpretation is correct, then these countries will see capital outflows once interest rates in the U.S. and elsewhere rise.

A third paper from the IMF, written by Christian Ebeke and Annette Kyobe, looked at the markets for emerging market sovereign bonds. Their results are based on data from 17 emerging markets over the 2004-13 period. They found that foreign participation in the market for domestic-currency denominated sovereign bonds increased the impact of U.S. interest rates on the yield of these bonds once a threshold of 30 percent had been reached. Similarly, an increase in the concentration of the investor base made the bond yields more sensitive to global financial shocks.

Are domestic “pull” factors always irrelevant for capital flows? Ahmed Shaghil, Brahima Coulibaly and Andrei Zlate of the Federal Reserve Board constructed a “vulnerability index” of macroeconomic fundamentals for a sample of 20 emerging market economies during 13 periods of financial stress, beginning with the Mexican crisis of 1994 and ending with the 2013 taper tantrum. They looked at the impact of their index upon a measure of depreciation pressure, based on changes in exchange rates and losses in foreign exchange reserves. They found that there was evidence of a linkage between the macro fundamentals and depreciation pressure during the global financial crisis and then again during the European sovereign debt crisis and the taper tantrum, but not before.

Why would the response of emerging market economies to domestic fundamentals become stronger during the most recent crises? Shaghil, Coulibaly and Zlate offer two reasons: first, it may be that foreign investors investors did not distinguish among the emerging market economies until the 2000s. But as the governments of these countries implemented different policy frameworks and the costs of gathering information about them fell due to technology, it became worthwhile to distinguish amongst them based on their individual characteristics. An alternative reason for the change over time could lie in a shift in the origin of the crises away from the emerging markets themselves. Therefore, investors have become more careful in examining the vulnerabilities of individual countries.

The analysis of the relative importance of domestic “pull” vs. global “push” factors should not be posed as a “one or the other” contest (see here). There is ample evidence to indicate that global factors have become increasingly important in driving capital flows across borders. If so, then the news that the VIX hit record levels last week is disturbing. Stock markets in the U.S. and other advanced economies have rebounded, but the emerging market nations face a period of sustained retrenchment as investors reallocate their funds in response to the surge in global volatility.

International Debt and Financial Crises

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The latest issue of the IMF’s World Economic Outlook has a chapter on global imbalances that discusses the evolution of net foreign assets (also known as the net international investment position) in debtor and creditor nations. The authors warn that increases in the foreign holdings of domestic liabilities can raise the probability of different types of financial crises, including banking, currency, sovereign debt and sudden stops. A closer inspection of the evidence that has been presented elsewhere suggests that it is foreign-held debt that poses a risk.

The role of international debt in increasing the risk of crises was pointed out by Rodrik and Velasco (working paper 1999), who showed that short-term bank debt contributed to the occurrence of capital flow crises in the period of 1988-98. More recently, Joyce (2011) (working paper here) looked at systemic bank crises in a sample of emerging markets, and found that an increase in foreign debt liabilities contributed to an increase in the incidence of these crises, while FDI and portfolio equity liabilities had the opposite effect. Ahrend and Goujard (2014) (working paper here) confirmed that increases in debt liabilities increase the occurrence of systemic banking crises. Catão and Milesi-Ferretti (2014) (working paper here) found that an increase in net foreign assets lowered the probability of external crises. Moreover, they also reported that this effect was due to net debt. FDI had the opposite effect, i.e., an increase in FDI liabilities lowered the risk of a crisis. Al-Saffar, Ridinger and Whitaker (2013) have looked at external balance sheet positions during the global financial crisis and reported that gross external debt contributed to declines in GDP.

There are also studies that compare the effect of equity and debt flows. Levchenko and Mauro (2007), for example, investigated the behavior of several types of flows, and found that FDI was stable during periods of “sudden stops,” while portfolio equity played a limited role in propagating the crisis. Portfolio debt, on the other hand, and bank flows were more likely to be reversed. Similarly, Furceri, Guichard and Rusticelli (2012) (working paper here) found that large capital inflows driven by debt increase the probability of banking, currency and balance-of-payment crises, while inflows that are driven by FDI or portfolio equity have a negligible effect.

Why are debt liabilities more risky for countries than equity? Debt is contractual: the holder of the debt expects to be paid regardless of economic conditions. Equity holders, on the other hand, know that their payout is tied to the profitability of the firm that issues the debt. Moreover, during a crisis there are valuation effects on external balance sheets. The value of equity falls, which raises the net foreign asset position of those countries that are net issuers of equity, while lowering it for those that hold equity. In addition, debt may be denominated in a foreign currency to attract foreign investors worried about depreciation. A currency depreciation during a crisis raises the value of the debt on the balance sheet of the issuing country.

These results have consequences for the use of capital controls and the sequence of decontrol. Emerging markets should be careful when issuing debt. However, the evidence to date of trends in the international capital markets shows a rise in the use of debt by these countries. Emerging market governments, for example, issued $69 billion in bonds in the first quarter. In addition, the BIS has drawn attention to the issuance of debt securities by corporations in emerging markets.

The IMF has warned of a slowdown in the emerging market countries, with the Fund’s economists forecasting GDP growth rates below the pre-crisis rates.  Speculation about the impact of changes in the Federal Reserve’s quantitative easing policies has contributed to concerns about these countries. If a slowdown does materialize, the debt that was issued by these countries may become a burden that requires outside intervention.