A colorful and informative article by John Dizard in the Financial Times on how emerging markets may not have dodged foreign currency exposure risk despite their central banks having very large foreign exchange reserves. It turns out their banks and major companies weren’t so prudent.
Dizard raises a second issue here, one that was discussed at greater length by Brad Setser, how the lack of access to dollar swap lines is causing emerging economies to be hit harder by financial tsuris than their first-world brethren. It is curious that China, with its massive FX reserves, has not stepped into this breach. A few billion here and there would give them enormous sway.
From the Financial Times:
The distressed asset buyer I was chatting with at the IMF/World Bank meetings in Washington pretty well summed up the tone of the buy side people cruising the halls and coffee shops. Cross-border assets were cheap, but on their way to cheaper.
The super rich who had crowded the meetings in past years were almost entirely absent. The scene reminded me of a post-nuclear environment. Many of the survivors, as we expected from science fiction movies, were cockroaches (bureaucrats) and mutants (compliance officers).
The stock market crashes and rich world rescue packages are last week’s chatter. The current topic among the remaining investors in the credit space are the “second-order effects” of reduced access to credit, particularly in emerging markets. The first-order effects of the crisis are so well known that they are even discussed by US presidential candidates.
The principal emerging markets sales desk pitch of recent years has been the expiation of the “original sin” of governments’ borrowing in foreign currencies. The crises of the 1970s and 1980s were all about sovereign borrowers running out of forex. So the sovereign borrowers moved to create effective local markets for government debt and accumulated huge forex reserves. Poof! – no original sin.
Except that the sin was merely transferred to the emerging market banks and companies. According to JPMorgan Chase: “Over the past three years, the sum of syndicated loans and bonds raised by EM corporates exceeded $1,300bn” although that is inflated by rolled-over, short-term facilities. That was no problem, as long as corporations and banks could roll much of those obligations forward as they matured. Oh, and as long as their ability to hedge against risks through derivatives markets was not impaired.
Joyce Chang, JPMorgan Chase’s head of emerging market credit research, says: “All of the emerging market policy people we have spoken to were surprised by how quickly their corporates were impacted by the crisis. Most of them were segmented until early to mid-September, when Lehman hit. That was the catalyst.”
Anecdotally, it seems that Wachovia’s freeze-up and litigious takeover led to a sharp reduction in short-term trade finance lines for Latin America. While I do not have numbers for the bank’s trade line exposure, I am told they were one of the biggest financiers for Latin American companies.
A lot of those companies, particularly in Brazil, managed risks through aggressive hedging of forex and commodities risk. The Brazilian authorities, I am told, estimate their companies had put on at least $25bn in foreign exchange hedges. The more sophisticated emerging market companies were hedging against commodities risks, and they are faced with margin calls on underwater hedges.
Corporate treasurers were listening to people who told them they needed to hedge against the possibility of $200 per barrel oil. Seemed a good idea at the time.
Now, to unwind those positions, they have to find banks or dealers willing to take their counterparty risk. Then they have to come up with the cash to pay the newly increased margins; that’s the cash that was supposed to come from the trade receipts they can’t finance.
The good news is that central banks such as Brazil’s and Mexico’s have big reserves they can commit. But even they have to draw the line somewhere. The interesting question for foreign creditors of the companies is where the line is drawn.
The rich countries don’t have enough cash either, but they have the next best thing: virtually unlimited swap lines with each other. Those have been a principal tool of the Fed to maintain capital flows between the US and Europe. Nobody bothers to consult the Bank of Canada’s forex reserves to see if they have enough dollars, since it could simply swap Canadian dollars for US in whatever quantity they need.
However, swap lines, or bilateral agreements between central banks for short-term, otherwise unsecured, exchanges of currencies, are rather smaller in the emerging market world. Asian countries have swap lines under the Chiang Mai Initiative, but they are tiny in relation to today’s capital flows. For example, Japan has swap arrangements with Korea for $7bn, Thailand for $3bn, Indonesia for $3bn and China for $3bn.
Even the big dog of lenders to the distressed – the International Monetary Fund – has total resources of about $200bn. Some stressed countries are in a better position than others, in part thanks to their past caution and on the part of their lenders. Turkey has proportionately fewer over-borrowed companies.
Russian risks would seem to be the most interesting. Yes, the central bank has more than $500bn in reserves, but which corporate borrowers will it support? There is no clear answer to that, for those outside the Kremlin.