How The Emerging-Markets Contagion Loop May Play
Slowing global trade is evidence of how emerging-market stresses are being transmitted to advanced economies. The real concern of contagion remains financial linkages, though.
Since 2009, non-resident gross flows into EM financial assets — loans, debt and equity securities — have averaged around $1 trillion annually, although the figure has been volatile. Total outstanding exposure, which remains opaque, may be around 50 percent of GDP in advanced economies.
The main driver has been accommodative monetary policy of developed-world central banks and the lure of higher returns.
Despite reductions, bank cross-border lending constitutes around half of the exposure. U.K., European, Japanese and Chinese banks are particularly vulnerable.
HSBC Holdings Plc and Standard Chartered Plc, which have large EM footprints, make up the bulk of U.K. advances.
Spanish banks have substantial amounts at risk in Turkey and South America. China’s risks via loans to EM borrowers as part of the Belt and Road initiative are also significant. Investors make up the bulk of the remaining exposure.
In the first instance, loan and investment losses, such as those reported by funds like Franklin Templeton, reduce wealth.
Creditors, in what is known as the common lender channel phenomenon, curtail lending to unaffected emerging markets and advanced economies as they seek to rebuild capital and realign risk.
In such a crisis, the larger role of investors with uncertain staying capacity complicates matters. “Index tourists” have purchased diversified portfolios to replicate EMs without detailed analysis of individual securities.
These investors may exit upon discovering the precise nature of their exposure from media headlines.
Redemptions will then force funds to liquidate to raise cash. Rating downgrades and market-value changes will cause index composition shifts or breaches in investment mandates that necessitate selling.
Unlike banks, which focus on actual non-payment, investors must react to unrealized, mark-to-market value changes. They aren’t prepared for lengthy workouts and debt restructuring and may sell rather than hold.
In previous EM crises, the IMF helped enforce property rights, benefiting foreign investors and lenders.
This time, consistent with its changed policies, the IMF may allow capital controls, in some form, as a part of any solution. That would affect asset values and reduce investor access to funds.
These factors may drive aggressive liquidation of holdings, pushing asset prices and EM currencies lower, exacerbating losses and the resulting contagion.
Secondary effects are important.
Volatility of and correlations among EM asset prices and currencies have increased. Around 40 percent of advanced-economy asset and foreign-exchange volatility on average can be explained by moves in emerging markets more in periods of crisis.
In a “risk-on, risk-off” environment, this flows directly into advanced-economy markets via risk models that require additional capital and collateral against positions.
The illiquidity of some EM assets and currencies necessitates cross-hedging, with investors selling correlated, liquid assets to manage risk.
Recent price changes in the Australian dollar, resource stocks and commodities reflect, in part, their utility in hedging emerging-market risks. This affects stronger economies in both asset classes.
While theory suggests that future cash flows determine prices, in practice all valuation is relative and based on cross-market comparisons. As asset prices adjust in emerging markets, a parallel reassessment in advanced economies is inevitable.
If EM stresses persist, then advanced economies face additional credit tightening, exacerbating the reductions in liquidity underway and potentially transmitting price shocks.
Mexican Treasury Secretary Jose Angel Gurria’s description of the financial contagion from the 1998 Russian default is salutary: “Ninety percent of Mexicans have never heard of the Duma, and yet the exchange rate and interest rates that they live with every day were being driven by people with names like Kiriyenko and Chernomydrin and Primakov.”
Today, investors in advanced economies concerned about their savings would do well to learn the names of key policy makers in troubled emerging markets.