Where are EM external vulnerabilities largest? - Capital Economics
Emerging Markets Economics

Where are EM external vulnerabilities largest?

Emerging Markets Economics Update
Written by William Jackson
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If the recent tightening of external financing conditions is sustained, it would result in severe balance of payments strains for the usual suspects (Turkey and Argentina) as well as some of the smaller EM oil producers such as Angola, Bahrain and Oman. The latter group could also suffer a double whammy of lower energy exports and reduced capital inflows.

  • If the recent tightening of external financing conditions is sustained, it would result in severe balance of payments strains for the usual suspects (Turkey and Argentina), but also some of the smaller EM oil producers such as Angola, Bahrain and Oman. The latter group could also suffer a double whammy of lower energy exports and reduced capital inflows.
  • The dust is still settling following the turmoil in markets on Monday. But it’s clear that external financing conditions for EMs have worsened. The spreads on EM sovereign dollar bonds have widened by 50-100bp since the start of the month. In many EMs, bond spreads have neared levels seen during the crisis fears of early-2016 and mid-2018. This will make it much more costly for EM governments and companies to borrow from abroad. And foreign investors may become more reluctant to invest in emerging markets.
  • There are lots of ways of looking at vulnerabilities to lower capital inflows. But our preferred indicator is the gross external financing requirement. This measures the sum of a country’s current account deficit and external debt maturing over the coming year. In other words, it measures the gross capital flows a country needs in the next 12 months to roll over maturing external debt and finance domestic demand.
  • If the country can’t attract these capital flows, residents (mainly the central bank) will have to sell external assets or the current account will need to improve. The latter can occur through weaker domestic demand (which depresses imports) and/or a fall in the currency which could lift exports (although that might be of limited benefit in the current environment) and encourage import substitution.
  • Chart 1 shows our estimates of the latest gross external financing requirements for a range of large emerging economies. We’ve measured this as a share of central banks’ foreign exchange reserves to provide a sense of the extent to which domestic policymakers can compensate for lower capital flows through asset sales.
  • There are two types of countries where vulnerabilities are most acute. The first contains some of the small oil producers, such as Bahrain, Angola and Oman. The fall in oil prices will, all else equal result in them running large current account deficits this year and reserve coverage is limited. We think Bahrain and Oman will receive financial support from the rest of the Gulf, limiting the risks to their dollar pegs. But policymakers in Angola will need to let the kwanza weaken further. (See our forthcoming Africa Update.)
  • The second group contains the usual suspects of more vulnerable EMs, including Argentina, Turkey, Ukraine and South Africa. Although current account deficits have narrowed in all three countries (and will do so further due to the fall in oil prices) they have large short-term external debts and limited FX reserves.
  • We forecast falls in all three countries’ currencies over the rest of the year. Of course, weaker currencies are not necessarily a bad outcome. Ultimately, it is part of the solution to these countries’ economic problems. But it could cause balance sheet strains in Turkey due to the large amount of FX debt in the private sector; in Argentina, it could hasten the move towards outright default on dollar bonds.

Chart 1: Gross External Financing Requirement (% of Foreign Exchange Reserves, Latest)

Sources: World Bank, Refinitiv, Capital Economics. External debt is on an original maturity basis.


William Jackson, Chief Emerging Markets Economist, +44 20 7808 4054, william.jackson@capitaleconomics.com