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Against the tide: Sovereign debt crisis – Global fever pitch

The contagion of a euro debt crisis will not be restricted to Europe’s weaker states.

The eurozone debt crisis will likely cause a recession in Europe; deleveraging in the US will also result in very low growth or recession; Japan’s economic recovery from the disaster is over. This all means there will be little or no growth role in the developed economies.

This is bad news for emerging economies. Exports from such economies to the three rich economic blocs represent more than 60% of GDP. Their export growth will slow sharply, as domestic demand is too small to take up the slack.

Emerging markets also need $1.6 trillion of foreign funding every year. The private sector in such economies remains in deficit to the outside world and only Asian economies have net foreign asset positions. All others have net foreign liabilities. As the private sector drives growth in emerging economies, they are vulnerable to a contraction in global liquidity and funding.

This is now on the cards. Deleveraging by European banks will be the cause. European banks account for 30% of Latin American bank credit and 40% of Eastern Europe’s. Now the European banks need to recapitalize to cover potential losses on the eurozone sovereign debt they own, meet the requirement to increase their tangible equity ratios and help in rolling over their own debts. This will cause European banks to deleverage and loan books to shrink. Lending to emerging economies will be the sacrificial lamb. A contraction in EU bank loans to emerging markets will spark risk-off attitudes in other potential creditors and investors too – another form of contagion.

Of course, the foreign assets held by the central banks and governments of many emerging economies provide a cushion to offset the withdrawal of foreign liquidity. They can salve the wounds of markets suffering from a lack of portfolio and hot money inflows, but not all international reserves are free for such purposes. Reserves also need to cover imports, provide backing to domestic money supply and act as a reserve to recap domestic banks, if necessary.

Exports to advanced economies
As a percentage of regional GDP and of total exports, 2010
Source: IMF, Independent Strategy

Indeed, if you adjust China’s $3.2 trillion foreign-currency reserves for these factors, there is little to spare at the end of the day. So international reserves in many emerging economies are adequate to do no more than smooth the transition to tougher external funding conditions and lower growth. Since 2008, the more volatile components (portfolio flows and bank loans) of FX inflows have provided nearly two-thirds of the rise in these reserves, with more stable FDI inflows providing only one-third. If these volatile flows reverse, they will make a large hole in the existing stock of FX assets, causing domestic liquidity contraction. This is the corollary of the failure to contain the liquidity explosion caused by foreign-currency inflows in boom times.

There are also knock-on effects on domestic credit if global bank credit contracts as a result of European banks’ deleveraging. Take China – it is the most monetized, credit-addicted emerging economy. China’s bank lending and broad money to GDP levels are consistent with those that caused a collapse of credit bubbles elsewhere. Then there is China’s shadow banking sector, which adds another 30% to 50% of GDP in credit over and above the official figures of 120% of GDP.


The other emerging economy at risk is Brazil. Sure, household debt is only 40% but the credit system is hopelessly distorted by the state banks’ dominance of corporate lending, which leaves the private-sector banks pushing loans at households. And household debt service levels are now higher than the pre-crash levels of US households.

Many emerging economies do not have a fiscal cushion they can use to offset bad times. The sovereign debts of Brazil, Hungary and India are all above 60% of GDP. China is just below that level. That’s the upper limit for developing economies. Beyond that, more sovereign leverage takes down growth.

And emerging economies have budget deficits too, while there is a bigger dependence on foreign funding to finance them. In 2012, the sovereign funding requirement (budget deficits and debt rollovers) for Brazil will be 19% of GDP, Hungary 15% and Poland 12%. By way of comparison, the eurozone Piigs total sovereign funding requirement is a bit above 20% of GDP.

The contagion of a euro debt crisis will not be not restricted to Europe’s weaker states.

David Roche is president of Independent Strategy Ltd, a London-based research firm.

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