Hot Money and Financial Activity in Commodity Exporters

Yves here. This article and the underlying World Bank paper are written in economese, but they tell a familiar tale of how commodity exporters become the victims of hot money flows.

By Joseph Joyce. Originally published at Angry Bear

Emerging markets and developing economies have struggled in recent years to regain the growth rates of the last decade before the global financial crisis. The slowdown has been particularly evident in commodity-exporters that face declining prices. The World Bank’s most recent Global Economic Prospects, for example, projects growth for those countries of only 0.4% in 2016. Moreover, the fall in commodity prices is linked to capital flows to those countries and an increase in the fragility of their financial sectors.

In a recent paper in the Journal of International Money and Finance, Joseph P. Byrne of Heriot-Watt University and Norbert Fiess of the World Bank examined the determinants of capital inflows to 64 emerging market economies. Among the drivers of capital flows were real commodity prices: an increase in these prices increased flows to the emerging markets, particularly total equity and bank flows. Real commodity prices also contributed to an increase in the global volatility of capital flows.

Commodity price cycles, therefore, should be associated with capital flow cycles, and declines in both may lead to financial crises. Carmen Reinhart of Harvard’s Kennedy School, Vincent Reinhart of the American Enterprise Institute and Christoph Trebesch of the University of Munich documented such a correspondence of capital flows, commodity prices and sovereign defaults during the period 1815 to 2015 in a paper in the American Economic Review Papers and Proceedings (working paper here). They found evidence of an overlap between booms in capital flows and commodity prices, which resulted in a “double bonanza,” and a “double bust” when capital flows and prices declined. They also recorded the incidence of sovereign defaults, and found that four of six global peaks in defaults followed double busts in capital flows and commodity markets. The most recent boom was exceptionally prolonged, beginning in 1999 and lasting until 2011, and was followed by a “double bust.”

Commodity prices can also affect the fragility of domestic financial sectors. Tidiane Kinda, Montfort Mlachila and Rasmané Ouedraogo in an IMF working paper looked at the impact of commodity price shocks on the financial sectors in 71 emerging market and developing economies that are commodity exporters. Negative prices weakened the financial sector as manifested through higher non-performing loans and reduced bank profits, and an increased probability of a banking crisis. The transmission channels included an increase in the amount of debt denominated in foreign currency as well as lower economic growth and less government revenues.

The fragility of the financial sectors of the commodity exporters has been exacerbated by a growth in private credit. The World Bank’s Global Economic Prospects has reported that credit to the nonfinancial sector in emerging markets and developing economies increased in the five years ending in 2015, and credit growth was particularly pronounced in commodity exporting countries. Much of this credit went to nonfinancial corporations, and the borrowing was concentrated in the energy sector. As a result, credit growth in the commodity exporting emerging market and developing economies has risen to levels of credit/GDP that in the past have been associated with credit booms that have often (but not always) been followed by bank crises.

Commodity price fluctuations, therefore, are accompanied by changes in capital flows and the status of financial sectors in commodity exporters. Booms in domestic credit can further threaten long-term financial stability. More flexible exchange rates may alleviate some of the strain of a downturn in commodity prices and capital inflows. But countries such as Brazil, Indonesia and Russia face little relief from the drag on their economic performance as long as commodity prices remain depressed. The accommodative monetary policies of the advanced economies have bolstered asset prices in many emerging markets, but that situation can not be counted on to continue indefinitely.

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  1. Grizziz

    Did not hot money flows into colleges and universities inflate the credentials they offered and now the credentialed are overburdened with debt and their capacity utilization low?
    Do economist believe in the infinite elasticity of the extent of the market that expands with their every utterance to the chagrin of the last leveraged investor at the frontier of the bubble?

  2. Jim Haygood

    “Countries such as Brazil, Indonesia and Russia face little relief from the drag on their economic performance as long as commodity prices remain depressed.”

    Yesterday’s news. Commodity prices bottomed in January. In turn, emerging markets equities [one of our holdings in craazyman fund] are cranking skyward, setting a fresh 12-month high just yesterday:

        1. Jim Haygood

          LamAm (Brazil + Mexico + Chile) comprises only an eighth of EEM’s portfolio, suggesting a global macro trend rather than an SA-specific story.

          Political factors have very little to do with this trend. A rising commodity tide lifts all emerging boats.

          MSCI is considering to promote Argentina from “Frontier Market” [an embarrassing status for LatAm’s third largest economy, which it shares with Third World luminaries such as Nigeria, Pakistan and Kenya] to “Emerging Market” next year, thanks to its liberalized capital controls.

          1. RabidGandhi

            Read my post below. The reason why ARG-BRA-VEN are susceptible to the highs and lows of the commodity tide is because they are becoming more and more commodity dependant.
            The scant industrialisation anchor we have is being removed: for example, within ten days of taking office, the Macri Administration removed grain export tariffs ($30bn), and hiked energy prices 600% to (partially) compensate. I.e., kick the chair out from industry and give it to the landowners to help them stuff money in the attic. This is why, yes it is a political factor: the current administration’s policies are to make us more dependent on commodity prices. If Argentina were more industry dependant, more diversified, Mr Market wouldn’t be throwing a party.

            All that said, one of the blessed catharses of recent years here is that most Argentines have learned to give f*ck all about the epithets given to us by the IMF, Moody’s, MSCI, WB… Except there is a small group that wants to get Good Citizen stars from our gaolers, and that lot happen to be in power (again).

            But we’ve seen this torrid telenovela before, so the ending should not come as a surprise.

  3. RabidGandhi

    Quick thoughts:

    1.- No time to read the underlying studies yet, but I suspect a commodity heavy EM’s propensity to suffer a financial crisis would be directly related to its GINI. In South America, at least, a boom in commodities means a big payday for the landowning oligarchs. In this sense, high commodity prices act like QE: the revenues don’t trickle down to the real economy, but rather the rich blow them on the ponies. Asset bubbles are created, and when they burst the public bears the costs.

    2.- This would be mitigated by three factors: (1) making the country less dependent on commodities (import substitution, developing domestic industry, bolstering internal market); (2) export tariffs that would force the oligarchs to feed the internal market first; and (3) capital controls forcing the rich with to invest their export windfalls domestically and not ship them off to the Caymans.

    3.- Take three examples of recent regime changes in SA’s biggest commodity exporters: Argentina, Brazil and Venezuela. Note that the degree to which their economies were diversified is the exact degree to which they have been affected by the recent downturn. Secondly, note that Item #1 on the agenda of the right wing groups taking over these three countries has been to undermine the 3 policies I mentioned above.

    1. Chauncey Gardiner

      Appreciate your insightful comments, RG, especially pertaining to the need for diversification and the reversionary policy drivers in Argentina, Brazil and Venezuela. Would only add two observations: First, that I believe unsustainable debt growth in China and the subsequent slowdown there have had a particularly significant effect on commodity prices, currencies and capital flows into commodity exporting nations, including Australia. Further, I question to what extent the actions of the policy elite in many EM exporting nations are determined by and coordinated with the desires of policy makers in another country?

      Given the secondary effects of the global debt overhang, it seems to me that a valid argument that commodity prices have recovered cannot be made until longer term technical price retracement levels are meaningfully exceeded.

    2. PlutoniumKun

      I think your point number 1 is very insightful – the concentration in benefits on landowning elites in South American has long led to political and economic distortions which has prevented the benefits of booms being translated into productive investments. A physical manifestation of this is the network of railways in countries like Argentina which are designed for the sole purpose of bringing commodities to one or two major ports. These become conduits for cattle (or whatever the major commodity may be) in one direction, and luxury goods to the local elites in the other direction. The lack of interconnectedness between these transport lines means they don’t provide a sound basis for regional industrial development. Its been called the ‘Appalachian effect’ – good transport links to wealthier areas actually prevents local businesses developing, because its easier to buy products in, and pay for it with local commodities. This is something economic geographers have long believed but it hasn’t had an impact on mainstream economic thought.

  4. RabidGandhi

    I question to what extent the actions of the policy elite in many EM exporting nations are determined by and coordinated with the desires of policy makers in another country?

    That’s a question I can’t answer for places like Australia, Indonesia or South Africa, but I can give you my inkling here in South America. I highly doubt the Macri or Temer regimes are receiving some kind of direct orders from Washington. But both have filled their cabinets with ministers plucked from the corporate world who have an unpolluted affinity for US policymakers. For example, both have finance ministers with deep ties to big banking (JP Morgan, GS, Itáu) who don’t need explicit orders from the IMF to know that it is their job to ensure the interests of the FIRE industries. It is in their professional DNA and they have been selected precisely for this reason. In Argentina, this holds true all the way through Macr’s cabinet, where every minister is ex-US-leaning big business.

    As to commodity prices and Chinese debt, that’s a question for PlutoniumKun or Clive, but from the sellers’ perspective here, I would repeat that we are too dependent on whether or not China is buying soy and corn. In fact, Argentina has a long history of this problem, as Perón tried to industrialise the country to the detriment of the landowners who eventually overthrew him in a coup (1956). The same battle continues today.

  5. Synoia

    Demand (Consumption) => China (Manufacturing) => Commodity Exporters

    Demand drives distribution and manufacturing, witch in turn drives oil (for distribution) and mining.

    Austerity Depresses Demand => Depresses China => Depresses Commodity Exporters.

    Based on an assumed value chain.

    If Demand is $20 => Distribution and China gets $10 each => Commodity Exporters get $2.

    This model suggests If your country is a commodities exporter your country needs to export 10x the value of exported goods to supply your country with enough dollars to support possible demand, as completed goods are much more valuable than raw materials.

    Which raises two questions, based on Raw Material = Commodity Exports.

    1. Can any country export enough raw material to make enough foreign exchange (dollars) to pay for the demand for finished goods?

    A test is to name Commodity Exporting countries with balance of payment surpluses (Saudi Arabia used to be the leader in balance of payments surplus, but not so much today).

    2.Is there enough raw material demand for all all exporting countries to pay for their aggregate demand for finished goods, or is there an explicit deficit built into this model of the world economy.

    If 2 is true, balances can be met by selling the commons (privatization,) and exporting workers (lower costs, more remittances). There are a limited volume of commons, and exporting workers is characterized by falling wages in the recipient countries, and consequent fall in demand.

    I think. (I could write Cogito ergo sum, but that would be very arrogant, and I’m not French).

  6. Mike

    I didn’t stay in a Holiday Express but I am reading Michael Hudson. The commodity exporters could even out the bonanza and bust cycles by using the money to build up real production and real labor strength and bypass the real estate speculation. Isn’t that the remedy to the neoliberal policies?

  7. Roscoe Cabriales

    Furthermore, hot money could lead to exchange rate appreciation or even cause exchange rate overshooting. And if this exchange rate appreciation persists, it would hurt the competitiveness of the respective country’s export sector by making the country’s exports more expensive compared to similar foreign goods and services.

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