How Linkages Fuel the Fire – My Take on the IMF World Economic Outlook

The IMF have just released a few of the chapters from their April World Economic OutlookEO. Here are the key conclusions from chapter 3:

“• The current crisis in advanced economies is much more severe than any since 1980, affecting all segments of the financial system in all major regions. For emerging economies, the current level of financial stress is already
at the peaks seen during the 1997–98 Asian crisis.
•There is a strong link between financial stress in advanced and emerging economies, with crises tending to occur at the same time in both. The large common impact of the current crisis, across all regions of emerging economies, is therefore not unexpected.
• Transmission is stronger to emerging economies with tighter financial links to advanced economies. In the current crisis, bank lending ties appear to have been particularly important.

•The current level of advanced economy stress and the fact that it is rooted in systemic banking crises suggest that capital flows to emerging economies will suffer large declines and will recover slowly, especially banking-related flows.

• Emerging economies obtain some protection against financial stress from lower current account and fiscal deficits and higher foreign reserves during calm periods in advanced economies. However, during periods of widespread
financial stress in advanced economies, they cannot prevent its transmission, although they may limit the implications of financial stress for the real economy (for example, reserves can be used to buffer the effects from a drop in capital inflows). Moreover, once financial stress recedes in the advanced economies, lower current account and fiscal deficits can help reestablish financial stability and foreign capital inflows.”

A key question answered in the chapter is the following: how does financial stress is transmitted from developing ecomies to emerging ones? What are the key factors? According to the IMF there are two broad reasons for financial stress. One is what they coined ‘common factors’ and the second one is the ‘country specific factors’, as displayed in the following figure:

Common factors can be global shocks (global shifts in market sentiment or risk aversion) and may manifest themselves through herd behavior in markets and lender effects. Given the high integration of the financial system , it suggests that a crisis in the develop world will necessarily have spillover effects in emerging economies that have financial linkages to the these developing countries. The IMF explains that the increasing in foreign liabilities of emerging economies is related to the increasing role of portfolio equity and direct investment. They then explain that:

“Although debt liabilities have declined somewhat over time, debt to advanced economy banks on a consolidated basis (with accounts of foreign affiliates consolidated along with those of the headquarters) has risen in recent years relative to GDP, and the composition has shifted from foreign to domestic currency debt (middle panel). Part of this process is attributed to the rapid increase in foreign bank ownership, especially in emerging Europe “

Country Specific Linkages

So what are the country specific linkages that can trigger financial stress? Well, clearly we have the two classical channels: trade and financial channels. Capital outflows from emerging economies (possibly to close positions in developing countries) triggering a depreciation of the domestic currency, loss of international reserves and it can become something that is self fulfilling. The second channel of transmission is trade. It can be measured by a decrease in exports to advanced economies due to an expected decline in demand. Clearly, the greater are the linkages between emerging countries and advanced ones, the greater is the impact of a decline in exports to advanced economies on the overall output of an emerging economy.

The IMF then compares the vulnerabilities of the main emerging markets: Latin America, Emerging Europe, Emerging Asia, Sub Saharan Africa, Middle East and CIS. With respect to current account balances, Emerging European countries are the ones carrying the largest current account deficits. This contrasts to many Asian countries that are showing surpluses mostly because of the commodity windfall. Fiscal balances show a more homogenous picture, having in general improved across all regions. Looking at the two indicators in combination shows twin deficits—on the current account and the budget—mainly in emerging Europe.

A second (inverse) measure of vulnerability is the level of foreign exchange reserves. Following the Asian crisis, many countries strengthened their reserve positions, as judged by months of import coverage. Commodity exporters and economies in emerging Asia—especially China—achieved large increases; other countries in Latin America and emerging Europe saw moderate increases. Overall, although reserve buffers have risen strongly in dollar terms, the increase in terms of import coverage has been less impressive as trade volumes have grown markedly.

Latin America, by all measures, (current account balances, fiscal deficits and international reserves) are better prepared to face the current financial crisis than the Eastern European countries.

The key lesson from this piece is that given that we live in a world with high financial linkage, the capital outflow from emerging economies due to the high risk aversion triggered by the crisis has a negative effect on developing economies (due to financial linkages). This suggests that advanced economies should stabilize their domestic financial system as a way to decrease stress to emerging economies. So for example, the support provided to Citibank was critical to Citibank in Mexico as well the Citi in Brazil, given the high exposure of Citibank in Latin America.

Another interesting aspect is that emerging economies should have access to external funding as a way of preventing negative spillover effects. This was the main idea behind the swap lines that the US Fed established with many emerging countries in October 2008.

In our opinion, the fact is that Latin American countries are in better shape to face the current international turmoil than it was in 1998 or 1982. Sound macro foundations with solid and stable political systems is the rule in South America. In this respect, it can be the case that investors might start to differentiate among emerging countries in South America and those in Emerging Europe, for example. South American countries, in general, not only have a more stable political system but more and foremost have stable and solid financial institutions, suggesting that it can receive large amounts of portfolio investment, especially when this storm is over.