Impact of the Global Crisis on Emerging Economies

1
Impact of the Global Crisis on Emerging Economies

• Lorenzo Giorgianni
• Chief of the Emerging Markets Division
• Strategy, Policy and Review Department
• International Monetary Fund
• Yerevan, Armenia
• July 7, 2009

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Outline

1. Origin of the global crisis
2. Impact of crisis on Emerging Economies
3. Global crisis response
4. Emerging Economies crisis policy response
5. Conclusions

3
I. Origin of the Global Crisis
4
Global warming (output)
2006
5
Global cooling (output)
2009
6
Root of crisis
The period of high growth and low interest rates
masked market as well as policy failures

• Financial regulation perimeter, procyclicality
• Macroeconomic policies asset prices, capital
  inflows
• Global architecture coordination, warnings,
  insurance

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Propagation of crisis

• 1. Financial centers
• Complexity of assets led to mispricing of risks
  (subprime lending)
• Realization of risks with fall in U.S. house
  prices
• 2. Advanced countries
• Globalization spread risks across assets,
  institutions, and countries
• Counterparty risks led to further tightening of
  banking standards and cross-border flows
• 3. Emerging market countries
• Increase in EM spreads and sudden stop turned the
  financial crisis in advanced countries into a
  full-fledged global economic crisis
• Feedback loops from EMs to advanced country
  banking systems

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Feedback loopsEastern Europe to Western banks
Losses from 20 percent loss on loan portfolio in
CEE (in percent of GDP)
Reduction in claims of international banks (in
percent of recipient country GDP)
First Round (from East to West)
Second Round (from Belgium and Austria)
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II. Impact of Crisis on Emerging Economies
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EMs hit by multiple shocks

• Sudden stop in capital flows
• External demand shock
• Terms of trade shock for commodity exporters
• Drop in remittances

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1. Deleveraging in advanced countries
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led to a sudden stop in capital flows to EMs,
notably Emerging Europe
Source IMF, World Economic Outlook
13
where stronger financial linkages amplified the
shock transmission.
14
Deleveraging means not only less availability
financing, but also higher borrowing costs.
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2. An external demand shock worse than in past
crises
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is leading to severe output contractions..
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which tend to be amplified by strong trade
linkages
18
as in Armenias case
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3. Fall in commodity prices hitting commodity
exporters very hard
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4. Lower incomes in advanced countries also means
lower remittances to some EMs
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Emerging Europe and CIS hit worst
Source IMF, World Economic Outlook
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But, are EMs innocent by-standers?
Vulnerabilities explaining market spreads
23
and cross-country differentiation in recessions
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II. Global crisis response
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Global crisis requires global response

1. Coordinated G-20 policy response
2. IMF reforms resources and lending framework
3. IMF lending

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A. G-20 fiscal response
Source IMF Fiscal Affairs Department Note
Discretionary stimulus (average, 2009-10, based
on measures announced through early March) plus
automatic stabilizers (average, 2008-10)
27
A. G-20 Monetary policy easing
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A. Liquidity injections/asset purchases since
January 2008
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A. Banking recap since January 2008
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B. IMF ReformsIncrease in resources

• Size of war chest in relation to potential needs
• Triple lending resources to 750 billion
• Raise 500 billion in bi-/multi-lateral
  agreements
• Commitments so far over 400 billion
• General SDR allocation of 250 billion
• Boosts country reserves by 75 of quota
• Some 100 billion of liquidity to EMs and LICs
• Later, quota increase

31
B. IMF ReformsMore effective lending

• IMF as first port of call for EMs in stormy
  weather
• More flexible lending large, frontloaded,
  contingent access to deal with all financing
  needs
• Conditionality better tailored to countries
  circumstances to reduce stigma
• Flexible Credit Line (FCL)
• High Access Stand-By Arrangements (HAPAs)

32
C. Increase in IMF lending
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C. Fund financing can play useful role

• Reduces need for adjusting to liquidity shock
• Allows orderly adjustment to solvency shock
• It does so by
• increasing reserves and catalyzing private
  lending
• bailing-in the private sector (Vienna initiative)
  
• creating room for spending reserves to (i) ease
  private sectors FX liquidity constraints, (ii)
  recap banks, and (iii) ease budget financing
  constraints
• Caveat to safeguard Fund resources, policies
  need to be consistent with capacity to repay

34
IV. Emerging Economies Policy Response (as seen
through the lens of the recent Fund-supported
programs)
35
EMs policy response often constrained

• Exchange rate regime
• Degree of dollarization
• Fiscal sustainability and credibility
• Bank solvency
• Institutional weaknesses
• Social considerations
• Political, electoral cycles

36
Focus fiscal policy in crisis

• Much emphasis has been placed on fiscal stimulus
  to counter effects of global financial crisis
• But many EMs face stricter constraints on their
  fiscal space than advanced economies
• Financing constraints
• Debt levels (for some)
• Credibility issues
• Accommodating bank recapitalization costs (for
  some)
• Strictures of Euro entry criteria (for some)

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Reflecting these constraints, fiscal deficits
were allowed to widen, but not fully
38
given the stock of public debt and other initial
conditions
39
Even so, fiscal programs are being flexibly
adapted to evolving macro conditions
40
Conclusions

• Global crisis spreading from advanced countries
  to EMs
• hit Armenia and other CIS/CEE countries
  particularly hard
• Required a coordinated global response
• fiscal and monetary stimulus where feasible
• emergency measures to support financial sectors
• The Fund has played a central role
• endowed with more resources overhauled lending
  framework
• launched substantial lending programs across the
  world
• New programs have had to adapt to the new crisis
• Exchange and monetary policies according to
  country circumstances
• Accommodative fiscal stance as possible given
  financing/sustainability issues attention to
  social safety nets
• Focus on maintaining financial sector health

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Thank you
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Back-Up Slides
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Crises are costly, come in waves andrequire
strong, comprehensive response
44
When will markets normalize?
45
Recent IMF lending in context
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Large Access, Short Duration
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Access is large and front-loaded
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Structural Conditionality
Non-core
Core
Core measures financial/monetary, exchange rate
and fiscal policy
49
Issues in crisis management

• Early diagnosis is key (liquidity vs. solvency)
• Deal with uncertainty (size of output gap?)
  adapt plans develop contingencies (abandon peg?)
• Secure legal authority to act
• Ensure good interagency coordination
• Premium on coherent communications
• Ensure adequate safety nets for disadvantaged
• Plan exit strategy

50
Evolving circumstances downgrade in growth
projections
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Exchange rate policy

• Should pegs be abandoned in crisis?
• Keeping pegs can lead to severe loss of
  competitiveness with respect to floaters
• Regaining competitiveness (or correcting
  overvaluation) under peg imposes harsh
  deflationary adjustmentplus it seldom happens in
  crisis (only Hong Kong and Panama)
• However, negative balance-sheet effects of
  depegging could be large when liability
  dollarization pervasive (although deflation in
  the context of peg also leads to insolvencies)
• Regional contagion is another risk of depegging
• Presence of a credible exit strategy from peg,
  including plans to join monetary union, is
  another important consideration
• Role of capital controls?

52
Exchange Rate Policy (continued)

• To what extent should a country with flexible ER
  intervene in the FX market?
• Appropriate to offset disorderly conditions,
  counter currency overshooting, and provide FX
  liquidity to banks
• However, to be effective, needs to be accompanied
  by rate hikes/active mopping up of domestic
  currency liquidity and be part of credible policy
  response
• Trade off use of reserves today with potential
  demand for reserve use tomorrow

53
Exchange rate developments in programs
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Monetary Policy in Crisis

• Considerations for appropriate monetary policy
  stance (flexible exchange rate regimes)
• Inflation pressures
• Inflation-fighting credentials of monetary
  authority
• Trade-off between (i) growth benefits from lower
  interest rates and weaker currency and (ii) costs
  of currency depreciation on unhedged balance
  sheets
• Trade-off between (i) LOLR function in face of
  deposit runs and (ii) avoidance of exchange rate
  overshooting/loss of monetary control

55
Monetary Policy Instruments

• Policy interest rates The reduction in interest
  rates in advanced markets has provided space for
  reduction in nominal interest rates in EMs,
  although country risk premiums have risen.
• Quantitative measures Especially useful when the
  transmission mechanism from policy rates to the
  rest of the economy may be impaired by
  non-functioning credit markets.

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Inflation pressures to persist, especially for
floating currencies
Source IMF, World Economic Outlook
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Fiscal policy automatic stabilizers operating in
Western Europe
y 0.8361x - 0.5989 R2 0.7149
Source IMF, World Economic Outlook
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but less evident in Emerging Europe
y 0.0858x - 1.4215 R2 0.0497
Source IMF, World Economic Outlook
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despite fiscal easing in 2009...
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Further Fiscal Policy Considerations

• Automatic stabilizers are preferable over
  discretionary measures to achieve fiscal easing
• More timely, better targeted (e.g. unemployment
  benefits), and more credibly reversed than
  discretionary measures
• Need to make room for stabilizing financial
  sector
• Government support for recapitalization with
  safeguards
• Investment expenditures and transfers targeting
  the unemployed or poorer households (which have
  higher propensity to spend) are effective
  stimulus measures
• Subsidies to specific industries and
  hard-to-reverse expenditures are not recommended

61
debt and deficit limits more respected in
emerging Europe, despite worse growth
Source IMF, World Economic Outlook
62
Financial sector policies in crisis

• Preserving soundness of financial systems key
  for
• domestic financial stability and economic growth
• stability of interconnected countries
• effectiveness of monetary policy transmission

63
Financial sector policies in crisislessons from
previous crises

• Avoid piecemeal approach
• Secure confidence of creditors/depositors
• Ensure upfront loss recognition
• Facilitate recapitalization
• Remove nonviable institutions
• Do not delay debt restructuring

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Coordination issues from diversified financial
links through parent banks
Concentration of Emerging Europe Exposure to
Western Europe, H1 2008 (Percent)
Source Bank for International Settlements,
Quarterly Review, June 2008. Note Country
names are abbreviated according to the ISO
standard codes. 1/ Emerging Europe exposure to
western European banks is defined as the share of
the reporting banks in each western European
country in the total outstanding claims on a
given emerging European country (both bank and
nonbank sectors). For example, about 42 percent
of Croatia's exposures to Western European
reporting banks is owed to Austrian banks, 38
percent to Italian banks, 13 percent to French
banks, etc. For the Baltic countries, 85 percent
or more of exposures to the reporting banks is
owed to Swedish banks.
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Phase 1 Contain Crisis

• Establish credible macroeconomic policies
• Provide needed liquidity
• All countries have done this
• Short maturity, collateral, penalty rates but
  need for flexibility
• Open market operations successful in sterilizing
  injections
• Protect depositors
• Most countries have done this
• Blanket guarantees successful but may be costly
• Depends on size of financial hole and
  restructuring alternatives
• Cover all liabilities except subordinated debt
  and equity
• Announce medium-term restructuring program

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Phase 2 Restructure Banks

• Diagnosis, focus on medium-term viability
• Recognize losses upfront
• Preserve viable, undercapitalized banks
• request time-bound recap/restructuring plans
• close oversight and prompt corrective actions
• Resolve insolvent, unviable banks
• not all institutions to be rescued
• close/merge and liquidate assets

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Use of Public Money for Recap

• Rationale To encourage private sector
  contributions (investor of last resort)
• Principles and safeguards
• All losses recognized/absorbed by existing
  shareholders
• Match private injections with government funds
• Government shares could have preferred status
• Government representation in Board
• Require operational restructuring/asset workouts
• Sweeteners (option to buy back government shares)
  
• Allow convertibility of state contribution to
  Tier 2 capital into Tier 1 capital if CAR falls
  below given ratio

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Phase 3 Manage Impaired Assets

• Resolution of debt overhang needed to restart
  supply and demand of credit
• Corporate debt restructuring often neglected
• Issues in institutional framework
• speed versus value
• centralized versus decentralized
• legal reforms (bankruptcy/foreclosure)
• out-of-court debt restructuring (London approach)

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Phase 4 Exit from Crisis Mode

• Exit from blanket guarantee if applied
• Exit from government ownership of banks
• Sale of assets taken over
• Overhaul of regulations to not repeat mistakes
• Continue corporate restructuring to avoid
  second-wave crisis

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Flexible Credit Line (FCL)

• Flexibility to draw or treat as precautionary
• Qualification Very strong fundamentals/policies
• No conditions after approval
• Access upfront, no cap
• expected not to exceed 1000 percent of quota
• Renewable arrangements, 6 months or 1 year (with
  mid-term review), repurchases same as SBA
• Safeguards Board scrutiny, transparency, PPM
• 3 users so far Colombia, Mexico, and Poland

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FCL Qualification Criteria

• Very strong fundamentals, policies, and policy
  track records
• Positive assessment from recent Article IV
• Qualification criteria (Annex 1 SM/09/69)
• Strength of external position, market access,
  sound fiscal position, low/stable inflation,
  absence of systemic bank problems, effective bank
  supervision, data transparency/integrity
• Not all criteria need to be met, but offsetting
  reasons needed

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High Access Precautionary SBAs

• HAPAs for members not eligible/do not request FCL
• All BOP needscredit tranche terms
• No hard caps, but exceptional access policy
  applies
• Phasing can move to 2 instead of 4 purchases a
  year, in relation to members strength/need
• Review frequency at least two a year
• Length flexible (up to 3 years)
• Need to solve blackout problem

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Access

• Normal access limits doubled
• 200 percent annually, 600 percent cumulative
• Exceptional access procedures modified
• Both precautionary/nonprecautionary use
• Same treatment in current/capital account crises
• Eliminate ambiguities (debt sustainability
  criterion

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Simplifying Surchages and Maturities

• Eliminate time-based repurchase expectations
  (effective immediately)
• Remove 100 bps surcharge for credit of 200-300
  of quota
• Keep 200 bps surcharge for credit above 300 of
  quota
• Introduce a 100 bps surcharge when outstanding
  credit is above 300 of quota for more than 3
  years

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Issues in crisis management

• Early diagnosis is key (liquidity vs. solvency)
• Deal with uncertainty (size of output gap?)
  adapt plans develop contingencies (abandon peg?)
• Secure legal authority to act
• Ensure good interagency coordination
• Premium on coherent communications
• Ensure adequate safety nets for disadvantaged
• Plan exit strategy

76
Exchange rate policy

• Should pegs be abandoned in crisis?
• Keeping pegs can lead to severe loss of
  competitiveness with respect to floaters
• Regaining competitiveness (or correcting
  overvaluation) under peg imposes harsh
  deflationary adjustmentplus it seldom happens in
  crisis (only Hong Kong and Panama)
• However, negative balance-sheet effects of
  depegging could be large when liability
  dollarization pervasive (although deflation in
  the context of peg also leads to insolvencies)
• Regional contagion is another risk of depegging
• Presence of a credible exit strategy from peg,
  including plans to join monetary union, is
  another important consideration
• Role of capital controls?

77
Monetary Policy in Crisis

• Considerations for appropriate monetary policy
  stance (flexible exchange rate regimes)
• Inflation pressures
• Inflation-fighting credentials of monetary
  authority
• Trade-off between (i) growth benefits from lower
  interest rates and weaker currency and (ii) costs
  of currency depreciation on unhedged balance
  sheets
• Trade-off between (i) LOLR function in face of
  deposit runs and (ii) avoidance of exchange rate
  overshooting/loss of monetary control

78
Financial sector policies in crisis

• Preserving soundness of financial systems key
  for
• domestic financial stability and economic growth
• stability of interconnected countries
• effectiveness of monetary policy transmission

79
Financial sector policies in crisislessons from
previous crises

• Avoid piecemeal approach
• Secure confidence of creditors/depositors
• Ensure upfront loss recognition
• Facilitate recapitalization
• Remove nonviable institutions
• Do not delay debt restructuring