While tensions in the financial markets remain elevated, investors should also keep in mind that the global economy is likely to enter a pronounced slowdown in the quarters ahead (see The Slowdown Goes Global, September 17, 2008). We fear that this economic trough will be synchronised across countries and will possibly be more protracted than we had thought. The focus of this note is to highlight one risk to EM currencies: not only will the EM economies experience a material slowdown, but the world’s capital flows to EM will also likely be significantly reduced, undermining EM currencies. Negative Outlook for the Global Economy Our US economists have had the view for a while that the US will likely fall into a recession in 4Q08 and 1Q09, for reasons most readers are familiar with. But the latest developments in the US financial markets may have further increased this risk, even though the proposed TARP may have reduced the risk of extreme outcomes. (The reason why the whole issue of the US financial system and mortgage-related asset prices is so intractable is because of the feedback loops through the housing cycle. The housing cycle and the financial sector feed on each other. Attempts to arrest this vicious circle will need to be determined and forceful, because of this circularity.) Many readers, we presume, appreciate that, as of Friday, September 19, the market closing prices for major equity markets, bond markets, credit and other assets essentially were no different from those that prevailed a week earlier (Friday, September 12). But we think the damage to the general risk-taking appetite for the entire financial industry is likely to have been material. The analogy we have in mind is one experiencing a severe car crash. Even if the insurance company provides a new car as a replacement and the doctors put the driver back in one piece, the driver is most likely not going to drive in the same way they used to. Risk is everything in the financial industry. A distinct shift in the industry’s collective risk profile will have a material impact on credit extension, and so we believe that credit conditions will likely become more restrained, even with the help of the TARP. While the TARP – if designed and executed right – has the potential to remove the risk of a financial disaster, it is unlikely to immediately halt the descent in housing prices in the US. The underlying fundamentals driving housing supply and demand will likely take several months to equilibrate themselves. Other familiar factors are likely to continue to drive the US into a soft patch, with implications for the rest of the world. Japan’s first trade deficit in 26 years, released this morning, is telling. At present, we expect global growth to decelerate to 3.5% in 2009, from 4.0% in 2008 and 4.8% in 2007. For EM, the IMF growth forecasts are 6.8% for 2009, compared to 7.0% for 2008 and 8.0% for 2007 (IMF World Economic Outlook). We are more pessimistic, expecting 6.5% growth in 2009, but the risk to these forecasts seems to be biased to the downside (see Global Forecast Snapshots, September 12, 2008). Capital Flows to EM A slowdown in the global economic growth rate will undermine capital flows into EM. This, we believe, is a major risk to the EM currencies. According to the Institute of International Finance (IIF) (see Capital Flows to Emerging Market Economies, March 6, 2008), private capital flows into EM totaled around US$521 billion in 2005 and US$568 billion in 2006, but surged sharply to US$782 billion in 2007. (This figure could be revised up further to above US$850 billion.) As of March, these flows were expected to abate modestly to US$730 billion this year. However, we believe that the actual flows are likely to be meaningfully lower than this figure, given that capital flows into EM are likely to have decelerated sharply in recent months. There is a positive relationship between global growth and the size of capital flows going into EM (measured as a percentage of the recipient countries’ GDP). There is also a similar positive relationship between these capital flows and the growth rate of the EM economies. • Observation 1. Global growth is an important determinant for capital flows. Our simple regression of these variables suggests that global growth is, interestingly, about twice as important a driver for private capital flows into EM as EM’s growth. In other words, the ‘push’ factors are more important than the ‘pull’ factors, and the developed world will need to be healthy and, presumably, be in a risk-taking mood for capital flows to be buoyant. What this means is that even if we have partial and temporary de-coupling between the EM and the developed economies, capital flows are likely to abate, if this historical relationship is still a useful guide. With the growth slowdown expected for 2009, capital flows to EM could decline to US$550 billion. • Observation 2. Portfolio investment is, somewhat surprisingly, not the dominant type of inflow to EM. Many, including ourselves, have in the past focused on how volatility in the global equity markets could alter global investors’ risk appetite and eventually capital flows and currencies. However, the fact is that portfolio flows are only a small part of total capital flows. There are essentially two types of equity flows (FDI and portfolio) and two types of loan flows (from banks and non-banks). Averaging over 2005-08, portfolio flows accounted for only 8% of total capital flows into EM, while FDI flows accounted for 35%. At the same time, loans from banks (32%) and non-banks (26%) accounted for 57% of the total net private sector flows into EM. This structure of capital flows into EM suggests that the financial health of the FDI investor may be more important than the future prospects of the EM economy in determining the size of the FDI flows. In turn, this notion is consistent with Observation 1 above that global, not EM, growth is the more important determinant for EM capital flows. Further, the fact that loans account for 57% of the total flows is also very important. The financial crisis in the developed world will likely have a direct impact on lending to EM, and loan repayment and hedging of these repayments could potentially be a force propelling EM currencies lower. • Observation 3. Chicken-and-egg relationship between capital flows and economies. Capital flows drive the EM economies, and the health of the economies in turn motivates capital flows. The latter link should be familiar to investors. Capital inflows tend to be positive for economic growth of the recipient country as they tend to depress interest rates, cultivate an expectation of future currency appreciation and enhance productivity as multinational FDI tends to embody good technology. A reversal in flows would have the opposite effect. In addition, often the macroeconomic policies in EM economies, when pressured by ‘sudden stops’ in capital inflows, are ‘pro-cyclical’, i.e., monetary and fiscal policies tend to be restrictive just as the economies slow. In EM, interest rates are often held high to prevent capital flight. A tight monetary stance can also be justified under an inflation-targeting scheme whereby a weakening currency should be offset with higher interest rates. On the fiscal side, often capital outflows from countries with less-than-robust fiscal positions force governments to run tighter fiscal policies. Pro-cyclical macroeconomic policies were implemented in Asia following the Asian Currency Crisis in 1997. What began as a currency crisis in Thailand quickly turned into a regional recession that lasted more than a year. We believe that a similar process could take place in some EM countries today if the capital outflows are violent enough. • Observation 4. We don’t expect a currency crisis, but such a scenario cannot be ruled out. Global capital flows into EM collapsed in the late 1990s, triggered by the Asian Currency Crisis in 1997 and the Russian default in 1998. Later, the bursting of the IT bubble in 2000 again undermined private sector capital flows into EM. In 2007, net private capital flows to EM (as a percentage of recipient countries’ GDP) exceeded the high that was set in 1996 – on the eve of the Asian Currency Crisis. Further, the absolute size of the cumulative flows into EM in the past five years (US$2.44 billion) is more than twice that during 1992-96 (US$1.05 billion). The cumulative ‘stock’ of capital inflows is important because it is a measure of the potential power of currency hedging or outflows. As the global and EM economies slow into 2009, we believe that the risks are highly skewed for EM currency weakness. The risk of a crisis is still low, but rising, in our view. Bottom Line After the turmoil in the past two weeks, we think the global economy has a higher probability of falling into a recession in the coming quarters. This bodes ill for capital flows into EM, which could potentially plummet from around US$750 billion during 2007-08 to US$550 billion or so by 2009. FDI, portfolio and loan flows are all likely to decline. In turn, the abatement in capital inflows to EM could undermine EM’s economic growth and pressure some EM currencies lower.
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Capital Flows and the BRIC Currencies
September 29, 2008
By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions In a separate note (Risks of a Sharp Reduction in Capital Flows into EM, September 25, 2008), we argue that global growth will be a key driver of capital flows into EM (emerging markets). A potential slowdown in the global economy in the coming quarters, therefore, poses a significant downside risk to capital flows into EM and, in turn, raises the issue of currency vulnerability in these EM economies. In this note, we examine the composition of the balance of payments (BoP) of the BRIC economies (Brazil, Russia, India and China). Our ranking: CNY not vulnerable, INR vulnerable, BRL and RUB somewhat vulnerable. Global Growth and Capital Flows into EM Net private sector capital flows to EM surged sharply from around US$550 billion a year during 2005-06 to US$750 billion a year during 2007-08. In fact, in 2007, these flows reached 6% of the GDP of the recipient EM economies – exceeding the level prevailing on the eve of the Asian Currency Crisis in 1997. For 2009, based on the relationship between global growth and capital flows, a slowdown in global growth could lead to a collapse in these capital flows back to the US$550 billion range. The currencies of various EM economies will have different levels of vulnerability, depending on the structure/composition of their BoP position. In this note, we examine the relative vulnerability of the BRIC currencies. The Varying Structures of the BRIC’s BoP The structure of the balance of payments (BoP) is an important determinant of currency vulnerability in times of risk-aversion. We break down the annual accumulation of official foreign reserves in Brazil, China, Russia and India into several components: trade balance (TB), foreign direct investment (FDI) and non-trade and non-FDI flows, i.e., the rest. (At present, China, Brazil, Russia and India have roughly US$1,800 billion, US$200 billion, US$600 billion and US$300 billion in official foreign reserves.) TB is a measure of trade and FDI is a measure of capital flows that may be more stable and less prone to speculative pressures. The ‘rest’ includes portfolio flows, loans, remittances and other investment flows that may be more ‘footloose’ and prone to being spooked by global volatility. Eye-balling the data for each country, we see fundamental differences among the BRIC economies, on this measure: • On trade, India stands out as the only country in this group with persistent and growing trade deficits. Recently, India’s monthly trade deficit just set an all-time record as it exceeded 10% of GDP on an annualised basis. In contrast, China, Brazil and Russia have run decent-sized trade surpluses in recent years: merchandise trade in China’s case, and commodity trade in the latter cases. • On FDI flows, again India stands out as the country that has received the lowest amount of net FDI inflows, in proportion to the annual accumulation of official reserves and in absolute terms. Russia has not been a major recipient of FDI flows either. In contrast, both China and Brazil have received healthy net FDI inflows. China, for example, received an average of US$83 billion in FDI flows in the last three years, compared to US$11 billion in Brazil, US$5.4 billion in Russia and US$5.6 billion in India. • On ‘short-term’ capital inflows, China stands out as the country that has been least reliant on these fickle flows, though the absolute size of these flows into China has also been large (about US$78 billion in 2007). Brazil’s reliance on ‘hot money’ flows became quite high last year – short-term flows accounted for 29% of the total reserve accumulation in 2007. In India, this figure is 164%. In the case of Russia, these flows turned from being negative for the past decade to a surplus in 2007. It is far from clear that Russia can continue to receive short-term flows of this type in the coming years. Investors should therefore be aware that in the case of a sudden negative shift in sentiment towards EM, or a wholesale abatement in flows into EM, China appears to be less vulnerable than Russia, Brazil or India. Relieving the pressure on the currencies would require a substantial willingness on the part of the respective monetary authorities to sell reserves. Also, to the extent that full sterilisation cannot be achieved due to constraints in the local bond market or other reasons, there could also be a net reduction in domestic liquidity arising from such large-scale sales of reserves. Of course, as the global economy slows, the trade balances of all three economies could deteriorate as well. Russia’s trade position would clearly be more sensitive to the fate of crude oil, while that of Brazil is more dependent on the prices of other types of commodities. In short, looking at the BoP positions of the BRIC economies, a prospective decline in capital flows into EM might be most damaging for the INR, and least so for the CNY. RUB looks somewhat better positioned than BRL. Thus, CNY > RUB > BRL > INR. Appendix 1: The Case of India The surge in capital flows into India in the past two years has been extraordinary. From an average annual flow of around US$18 billion during 2002-06, private capital flows into India accelerated to US$42.6 billion in 2006 and US$90.2 billion in 2007. Portfolio equity flows dominated this surge, accounting for about 70% of the increase from 2006 to 2007. This sets India apart from the rest of EM, which did not see portfolio flows as the key driver. Thus, more than other EM currencies, the INR is likely to be quite sensitive to the performance of the global and local equity markets. Incidentally, this special feature puts INR in the same category as KRW, which is also sensitive to equity market performances. Further, there is the issue of currency hedging on the existing stock of equity holdings foreigners have in India. In addition to robust economic fundamentals, investors should also be aware that India does not have a problem with external debt. Total external debt, as a percentage of exports, has declined from around 150% in 2002 to 96% now. The interest payment on external debt is around 3.5% of exports. In short, the INR looks more vulnerable than the other BRIC currencies. As long as the global and regional equity markets remain volatile and anaemic, the INR is likely to continue to weaken as portfolio capital is pulled from EM. Other EM economies will also be vulnerable to a cut-back in international loans, though India does not look vulnerable to this specific risk.
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