Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Emerging Markets Face Growing Capital Account Pressures

March 19, 2009

  • Emerging markets may need large-scale official support
  • Emerging economies should prepare contingency plans for corporate failures
  • Global deleveraging sharply reducing demand for emerging market assets

Emerging market countries are facing increasing difficulties around the world because of the spreading economic crisis, with demand falling for their exports, investment slumping, and cross-border lending drying up, according to an assessment by the IMF.

Emerging Markets Face Growing Capital Account Pressures

Market data in Warsaw, Poland: emerging market banks in central and eastern Europe, may need to be recapitalized, IMF says (photo: Kacper Pempel/Reuters)


An analysis, prepared for the Group of Twenty (G-20) industrialized and emerging market countries, said that many emerging market economies are likely to face prolonged capital account pressures. Some governments may have to support companies in their countries that are unable to raise financing to roll over their debt. Emerging market banks, especially in central and eastern Europe, may need to be recapitalized in view of prospective losses.

As the crisis becomes more prolonged, a growing number of emerging economies will find room for policy maneuver becoming increasingly limited. “Large-scale official support is likely to be needed from bilateral and multilateral sources,” the analysis, made public by the IMF on March 19, said.

Overall, risks are largest for emerging economies that rely on cross-border flows to finance current account deficits or to fund the activities of their financial or corporate sectors, the analysis said.

Fallout from advanced economies

Escalating bank losses in advanced economies are pushing banks to contract balance sheets and curtail credit flows to hedge funds and other emerging market investors. The result is that cross-border lending is contracting, which threatens to starve emerging market firms and banks of financing. Emerging market companies that accessed external funds (through bonds and loans) will need to turn to domestic markets.

Hedge funds and institutional investors, including pension and mutual funds, continue to pull capital out of emerging markets on account of severely reduced financing and heightened redemptions pressures at home. Many who still hold large exposures in relatively illiquid assets are seeking to reduce their exposures as market conditions permit.

Emerging bond markets have already come under severe strain, with deteriorating conditions in both primary and secondary segments. But, following a virtual shutdown of emerging market sovereign and corporate bond financing in the final quarter of last year, some borrowers have been able to obtain funding more recently, albeit at substantially higher spreads.

Global deleveraging also clouds the outlook for portfolio investment and foreign direct investment flows to emerging economies. Significant portfolio outflows in 2009 and 2010 are likely, given continued pressures for leveraged investors to shed assets, risks to dedicated investors of further redemption pressures, and crowding out from government-guaranteed mature market bonds.

Foreign direct investment is set to slow significantly, given the fall in private equity assets, the lack of credit available to finance acquisitions, and sharply deteriorating growth prospects in emerging markets.

Banking sector vulnerabilities

Corporate and banking sector vulnerabilities are becoming mutually reinforcing in several emerging economies, the IMF noted. Relatively high requirements to roll over debt in the year ahead could rise further as some debt claims are accelerated due to breaches in original covenants.

With falling commodity prices and growth slowing sharply, defaults in the corporate sector are widely expected to rise, which would further strain bank balance sheets. In this environment, many banks are already curtailing credit growth, exacerbating the financing constraints for companies and businesses.

Emerging market banks, especially in Europe and the Commonwealth of Independent States (CIS), may need to be recapitalized. With sharply weakening economic activity, a higher cost of capital, and deteriorating asset portfolios, many emerging market countries will need to address banking sector vulnerabilities, the IMF said.

Based on a sample of asset portfolios of some 750 banks in emerging market countries and the likely losses accruing on both securities and loans over the next two years—about $750 billion—the IMF’s preliminary analysis suggests a capital shortfall of about $250 billion, after accounting for retained earnings and use of capital cushions. The bulk of the shortfall lies in emerging Europe and the CIS, the IMF analysis states.

While mature market parent banks may have enough capital to recapitalize their subsidiaries in one or two countries, they are unlikely to have enough capital to recapitalize all of their subsidiaries. Agreements between individual emerging European countries and their parent banks that protect subsidiaries in a particular country may thus be detrimental for other countries in the region, underlining the need for a cooperative approach.

Trade risks

The IMF said the specter of trade and financial protectionism was a rising concern”. “Notwithstanding commitments by G-20 countries not to resort to protectionist actions, there have been worrying slippages,” the IMF analysis said. Referring to interventions in advanced economies, the Fund said lines were being blurred between public intervention to contain the impact of the financial crisis on troubled sectors and inappropriate production subsidies to industries whose long-term viability is questionable.

Some financial support measures are also steering domestic banks toward local lending. At the same time, there are growing risks that some emerging market economies facing pressures in their external accounts may seek to impose capital controls, the IMF said.

Balancing the policy response

In emerging economies, monetary policy has to balance the need to support demand against the risk of accentuating capital outflows and undermining financial stability, the IMF said. While slumping demand justifies easing of interest rates, increasing risks to external stability in the context of rising external financial constraints argues for a halt in rate cuts and even for a tightening of monetary policy in some cases.

Similarly, countries with pegged exchange rate regimes may have little scope for interest rate cuts to the extent that the crisis has put sustained pressure on their exchange rates. Some countries may need to increase the flexibility of their exchange rate regime, while ensuring the maintenance of a credible anchor for monetary policy.

With constraints on the effectiveness of monetary policy, fiscal policy—including increased spending on infrastructure, job creation, and cash transfers to the vulnerable—needs to play a central role in supporting demand, while remaining consistent with medium-term sustainability, the IMF recommended.

Contingency plans

Emerging economies should prepare, on a contingent basis, plans to address the growing risks of large-scale corporate failures, the IMF advised. Comprehensive mechanisms are needed to reduce the risk of systemic solvency problems, along with a strengthening of corporate workout frameworks.

Countries should assess their preparedness for dealing with possible bank runs, including whether existing mechanisms (such as deposit insurance schemes and banking resolution mechanisms) are sufficient or if they need to be bolstered. Similarly, legal frameworks for corporate insolvencies may need to be put in place or modified to promote efficient and predictable resolution of mounting debt problems in the corporate sector.

Comments on this article should be sent to imfsurvey@imf.org