Trust and Credit in Emerging Markets

Stephen DeAngelis

November 6, 2008

We’ve all heard about the butterfly effect — the notion that a butterfly can gently flaps its wings somewhere in the world and set in motion a series of events that result in catastrophic wind damage thousands of miles away. The current financial crisis is something like that. It began with easy credit being given to people who couldn’t afford it and with so-called “liar loans.” The simple act of lying on a credit form — repeated hundreds of thousands of times — set in motion a series of events that has resulted in catastrophic financial damage thousands of miles away in emerging markets. These emerging markets represent the future of the global financial system and governments are trying to find ways to throw them a lifeline. Kemal Dervis, executive head of the U.N. Development Program and a former minister of economic affairs and treasury in Turkey in 2001 and 2002, wrote an op-ed piece explaining why emerging market countries need and deserve help [“Fairness for Emerging Markets,” Washington Post, 3 November 2008]. He writes:

“The crisis that has threatened the global economy since August 2007 has unfolded in an accelerating succession of phases. October’s phase was the spread to emerging markets. A key step in fighting what could become a severe worldwide depression is making massive credit lines available to most emerging-market economies, which have been experiencing the repercussions of the deleveraging and associated credit crunch in the advanced economies. … Almost all emerging-market economies are running into financing difficulties. The problem has been getting worse as big, internationally active banks hoard liquidity, as capital is repatriated to financial centers and as rich countries’ gross domestic products contract. Some currencies have lost 30 to 50 percent of their values against the dollar, upsetting corporate balance sheets. The risk spreads in bond markets have risen steeply, and access to loans or loan rollovers has become increasingly difficult to get for sovereign and non-sovereign borrowers from emerging-market economies.”

As I have repeatedly noted, globalization advances primarily on three important flows: the flow of capital, the flow of resources, and the flow of people. Significantly disrupt any of these flows and the global economy suffers. Credit is essential to keep capital flowing. It is just as important in the global economic system as it is within national economies. Credit, however, requires trust; and in these financial dark times, trust is hard to find. Trust is often expressed in terms of “eligibility,” a subject addressed by Dervis.

“Many have argued for concerted action involving large International Monetary Fund loans accompanied by credit lines from the European Central Bank as well as the central banks of Japan, the United States, China and some of the reserve-rich Gulf states. The IMF announced a plan Wednesday to create a short-term liquidity facility designed to channel funds quickly to eligible emerging markets with “track records of sound policies, access to capital markets and sustainable debt burdens,” as well as policies that “have been assessed very positively by the IMF” in its most recent discussions with those nations. And the Federal Reserve has announced new or enlarged swap facilities that Brazil, Mexico, Singapore and South Korea will be able to access. Eligibility criteria to these credit channels and how these will be perceived are critical. Mexico’s initial reaction to the IMF plan, for example, was that it did not need it, a response probably facilitated, at least in part, by the swap line made available by the Fed. What should not be allowed to emerge is a scenario in which a small group of countries that the IMF and rich countries’ central bankers deem to have good track records have automatic access to large credit lines, while countries that are deemed riskier or that have less systemic importance or political clout have to apply for more traditional IMF programs, which take much longer to put in place and for which more extensive and intrusive conditions would apply. An ‘all or nothing’ categorization will create serious political tensions.”

Dervis understands that taxpayers in countries that provide loan money are weary of shelling out more funds to poor nations only to have countries default on the loans and then cry for debt relief. It is a storyline that has played out too often and one that almost always involves corruption. This, however, is not the storyline behind the current financial crisis. We are talking about viable economies caught in a credit crunch. He writes:

“Of course, it is not feasible or reasonable to open automatic access to what could be hundreds of billions of dollars of credit to a large number of developing countries without any eligibility criteria. But selecting only a few for such access and asking many others to engage in protracted negotiations will create great stigma for those countries left out and could, in fact, push them into crisis even faster. It will also make it politically difficult for these governments to engage in such negotiations if other countries have immediate access to assistance from the IMF or central bank swaps. It would be more constructive to expand access to the new IMF lending facility to a greater number of countries with reasonably good economic policies over the past few years. Broadening access could be achieved by an interpretation of the announced eligibility criteria that makes it clear that this facility is not aimed at a select few. In the end, decisions will have to be made case by case and should reflect the widespread need for varying doses of fiscal stimulus in the face of collapsing demand for exports and declining private expenditures.”

Dervis recognizes that globalization has created some new players in the financial sector and he encourages those new players to get involved.

“IMF resources could provide up to about $200 billion, but global needs are estimated at $500 billion to $800 billion. IMF loans, then, will have to be complemented by central bank credits, hopefully including credits from China and some of the Gulf states. A way should be found quickly to associate new actors such as China in a much more substantial way with the design and decision making relating to these facilities, pending more fundamental reforms in IMF governance.”

Dervis’ main argument is that helping emerging market countries is in the best interests of everyone. Rising middle classes represent new markets and new opportunities. Dash their hopes and ambitions and the effects of the current financial crisis are likely to deepen. He concludes:

“Emerging markets cannot be easily or simply labeled as those with good policies and those with bad policies. There are degrees of strength in policies and prospects, and a comprehensive approach will have to recognize the continuum rather than oversimplifying and opening the way for dramatic and politically sensitive all-or-nothing choices. A massive, comprehensive effort is needed immediately to extend support to hundreds of millions of people who bear no responsibility for creating the crisis that threatens their jobs and livelihoods. There must be decisive action on an imaginative design — not months from now but in the next two weeks.”

An example of an emerging market country that has been caught up in the latest financial turmoil is Romania [“Financial Crisis Leaves Romania Reeling,” by Craig Whitlock, Washington Post, 5 November 2008].

“In recent days, this once-booming country has been pounded by aftershocks from the global financial crisis. Speculators have attacked the local currency, the leu, betting that it would plunge in value. At one point last month, the stock market had dropped by 70 percent. By next year, some analysts predict, the jobless rate could double. Like many of its East European neighbors, Romania is experiencing a sudden reversal of fortune. After years of record economic growth fueled by easy credit and heavy foreign investment, people here are bracing for a sharp slowdown that they hope does not turn into an outright crash. Two of Romania’s neighbors, Hungary and Ukraine, already have been forced to accept bailouts from the International Monetary Fund. Next-door Bulgaria, with a bulging current-account deficit, has troubles of its own. To the north, the Baltic states are also feeling a severe pinch, with consumers deeply in hock to stressed Scandinavian banks. The European Union, which many of the former Soviet satellite countries thought would bring them stability, hasn’t offered much help.”

Unlike many countries, Romania is not yet seeking a bailout package.

“Officials here have brushed aside talk of an IMF bailout, which would be a setback for a country that joined the E.U. just last year. They especially reject comparisons to Iceland, which has been hit so hard that bankrupt entrepreneurs are now looking for jobs as cod fishermen. … At the same time, [Mugur Isarescu, the governor of Romania’s central bank] and other officials said Romania has serious challenges to overcome. The central bank has raised interest rates seven times in the past year. Last month, it was forced to intervene in the currency markets to prop up the leu, which traders were betting would collapse against the euro. … Romania plans to adopt the euro in 2014 but needs to meet a number of economic benchmarks before it can do so. Romania’s biggest problem is its current-account deficit: Far more money has been pouring into the country than going out. Much of the money comes from the estimated 2.5 million Romanians — more than 10 percent of the population — who work in countries such as Italy and Spain and send earnings back. But with those economies now suffering as well, many emigrants are expected to return home empty-handed. The deficit has tripled in the past five years, making the Romanian economy vulnerable if foreign investors suddenly pull out.”

I have noted before that foreign direct investment is a more sure path to economic development than foreign aid. There is an important difference between foreign investors and foreign direct investment. The kind of foreign investors that worry Romanian officials are not those involved with FDI, but those involved in pure capital investments. It’s easy to take your money out an economy; it’s much more difficult to close down production facilities and processing plants.

“‘We were flooded with foreign capital after joining the E.U., and now it is drying up,’ Isarescu said. He said a slowdown in economic growth and devaluation of the leu could be good therapy for Romania in the long term — but only if it happens gradually and in an orderly manner. ‘We have to prepare the country for a soft landing,’ he said. ‘In the morning, it is good to take a cold shower. I recommend it to everyone.’ Private-sector analysts, however, have been predicting uncomfortable times. In a report last month, Goldman Sachs rated Romania the second-most vulnerable economy in Eastern Europe, after Hungary. And last week, the Standard & Poor’s rating agency downgraded Romania’s foreign currency credit rating to junk status. Although the leu has stabilized in recent days, analysts said it is just a matter of time before currency traders mount another attack.”

Romanians thought they were in better shape to ride out the current crisis than many emerging market countries. Speculators, however, betting on the collapse of the leu, are making times more difficult than they need be.

“Since joining the E.U. last year, … Romania has seen a surge in economic growth. Its gross domestic product jumped by 9 percent in the second quarter this year. Cranes crowd the skyline in downtown Bucharest, the capital. The streets are clogged with shiny new Dacias, a boxy sedan made at a plant owned by Renault, the French auto manufacturer. Foreigners dominate the financial sector; three of the four biggest banks in Romania are based in Austria. In recent years, they were seen as a blessing. Consumers eagerly took out mortgages and car loans in currencies such as the euro and the Swiss franc, which offered much lower interest rates. With the leu weakening, however, it has become more expensive for Romanians to pay off their foreign debts.”

The same story can be told about many other emerging market countries. In Romania, people have stopped buying and are afraid to borrow money. Fear must be replaced with hope. At the same time, credit must be extended in an economically sound way. Consumption based on risky credit creates rather than solves problems. Romania sits on the cusp of prosperity and letting it slide back into the morass of poverty that gripped it while it was part of the Soviet bloc would be unwise. The same can be said about most emerging market countries. Financial isolation is no longer an option in a connected world. In the NBC television series Heroes, characters were told, “Save the cheerleader and save the world.” Today’s heroes need to save emerging market countries to save the world.