Moving into a Low Pressure Area?

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Moving into a Low Pressure Area?

• The Financial Sector Post-Crisis Challenges and
  Vulnerabilities
• Brookings Institutions
• by Khalid Sheikh
• Head Emerging Markets Analysis Multilateral
  Organisations (EMA MO)
• ABNAMRO Bank NV
• April 26-27, 2005

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Contents

• Benign environment
• Need to recalibrate compass
• Key risks to emerging markets
• Perfect storm
• Consequences

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Benign Environment Notion

• Recovery in International Capital Flows
• Improvement in Net Liability Positions
• Diversification in maturity distribution
  Sovereign Debt
• Credit Quality improved , reduced cost of capital
• More Fiscal restraint and responsibility
• Strong domestic investor base in Emerging
  economies
• Higher Commodity Prices

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Performance outlook by Region
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Benign environment Reality?

• EMBI lost? Spreads DO NOT reflect
  real risks
• Herd mentality doubts about loyalty of
  investors
• On average debt ratios for EM still high compared
  to 1990s
• Growing vulnerabilities to externalities
• How sustainable is Chinas growth?
• What is Rational Behaviour ? Do Not assume policy
  makers to act rationally.

No room for complacency
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EMBI lost?
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and what about RatingsTrade finance is a key
source of finance for less creditworthy countries
Trade finance by commercial banks, by investment
rating, 1980-2003
Percent of total bank lending
Non-investment grade and non-rated
Investment grade
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Need to Recalibrate Compass

• Markets are risky
• Trouble runs in streaks
• Markets have a personality
• Markets mislead
• Market time is relative

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Financial flows sustainability to finance the US
current account deficit

• A further depreciation of the USD could increase
  the risk premium demanded by foreign investors on
  US assets.
• This could lead to market volatility and a sharp
  increase in long-term bond yields.
• This would increase the EMBI spreads even higher.
  The vulnerability of heavier indebted countries
  increases significantly in this scenario.

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However, we still expect an orderly adjustment of
the USD

• US remains pacesetter for global growth and
  innovation
• USD remains an anchor currency
• Other countries should therefore still be
  prepared/have no other choice to invest their
  excess savings in the US
• Even if the USD would fall quite sharply, there
  are "automatic corrective factors" domestic US
  investors repatriating their foreign held assets
  due to changes in relative asset prices. Fed
  further increases interest rates, resulting in
  new investment inflows to the US

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Public finances are a key vulnerability for
emerging markets going forward

• Fiscal performance/discipline to generate primary
  surpluses Turkey / Brazil and India /
  Philippines.
• More debt issued in domestic markets and domestic
  currency with shorter maturities, which means
  that interest rate fluctuations can translate
  rapidly in debt service
• For many countries, LCY real interest rates are
  the primary determinant of debt service. In some
  cases, inflationary pressures keeps interest
  rates very high.
• Exchange rates and their path also matter.

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Public debt developments last 10 years
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Public debt developments last 5 years
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Public debt composition
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Anatomy of Financial Crises
Origin of crisis could initiate from any
particular point
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Risks on the Horizon

1. Renewed sharp increases in US current account
   deficit and related dollar crash
2. Oil prices structurally at USD 70 plus
3. Rising trade tensions
4. Hard landing in China
5. Globalisation is double-edged sword
6. More stringent Governance and Basel 2 could
   curtail the supply of resource flows

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Impact
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A new round of Crises? given worrisome
comparisons between the low pressures of the
1980s and the 2000s

• World imbalances are bigger
• Capital markets are bigger
• Inflation is lower
• World growth is more fragile Germany and Japan
  cannot help
• More countries have to be involved in the
  adjustment process
• Little appetite for coordination

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New chain of sovereign crises?
Russia August 1998
US 2005?
China 2007/2008?
Asia July 1997
Brazil January 1999
Argentina December 2001