In a recent paper submitted to the G20’s working group on international financial architecture, scholars with the Bank for International Settlements have warned that an accumulation of debt in the years since the global financial crisis has left the emerging market economics (EMEs) vulnerable to capital outflows.
The authors of the report are: Nikola Tarashev, Stefan Avdjiev, and Ben Cohen. They observe that the debtors involved in this accumulation are largely non-financial corporations (NFCs). NFC debt in the major EMEs increased in aggregate terms from less than 60% of nominal gross domestic product in 2006 (that is, before the crisis) to 110% at the end of 2015.
The same ratio in the developed economies has been flat for most of that period. It increased from 80% to 90% of nominal GDP from 2006 to 2009, topped out then, and has been at about 88% for most of the time since.
An Italicized Remark
In the course of making their point about financial vulnerability, the authors make the italicized remark that “gross flows matter at least as much as net flows” in understanding both recent financial history and current vulnerabilities. This is itself an important methodological issue. There is a temptation to focus on nets and, accordingly, on current account balances.
Ahead of the 2007-09 crises, for example, European countries had balanced current accounts. Asian countries had net surpluses in their current account balances. But what mattered was the exposure of banks in both regions to the U.S. housing market, which was much larger for the European banks than for the Asian banks, due to sizeable gross flows in the former case.
Thus, the authors infer, “a balanced current account with offsetting flows and positions may provide a false sense of safety.” So it will prove (they suggest) if a future crisis is set off by the leveraging of the EM nation’s non-financial corporates. If the NFCs do start experiencing pressures from outflows, the fact that their country’s central banks have large foreign exchange reserves will likely do the no good at all.
Those Domestic Credit Cycles
A related point: gross international capital flows have a tendency to amplify domestic credit cycles. The authors refer in this context to a 2011 study published in the BIS Quarterly Review in 2011, “Global credit and domestic credit booms,” by Claudio Borio, Robert McCauley, and Patrick McGuire. That study showed the extent to which external (cross-border) credit tends to grow more rapidly than over-all credit during boom periods. It made specific reference to the case of Ireland, where banks began in 2004 to support their domestic lending by net cross-border financing and by 2008 cross-border borrowing, by banks or non-banks, amounted to more than half the total debt of businesses and households on the country.
But let’s return to the reasoning of Tarashev et al. They are concerned that capital flows “can generate self-reinforcing asset price dynamics.” [Resume at p. 12.] There are various channels for these dynamics. For example, as a particular currency depreciates, borrowing in that currency tends to increase. The simplest case is that in which inflows in themselves enhance the perception of stability and growth vis-à-vis a specific nation, and that encourages further inflows. Or, when the turn comes, outflows encourage further outflows.
A slightly more subtle way in which EME leverage can feed on itself involves the depreciation of a foreign currency, for example the U.S. dollar, in which any NFCs do their borrowing. The depreciation increases the net worth of EME corporations that have borrowed in that currency and bought assets with a value denominated in the home currency. This higher net worth enables and encourages still more borrowing and illusory balance sheet improvement.
If the financial vulnerability of the EMs facing such leverage and such dynamics among their corporates is itself worrying, as a potential platform for the next crisis, the imperfection of the data necessary to get a very clear picture of it is more so. Tarashev et al end with a call for “the successful implementation of data gap initiatives.”