How to prevent financial crises in emerging markets

After a brief survey of Argentina and Turkey, two countries grappling with a financial crisis, Kavaljit Singh warns of the danger of a financial contagion impacting the emerging markets of Asia. While stressing the importance of capital controls and macroprudential tools to ensure financial  stability, these, he argues, may not be enough to withstand financial shocks in the absence of international cooperation.

ARGENTINA'S currency crisis is deepening. On 29 August, the peso crashed more than 7% - the biggest one-day fall since December 2015 when President Mauricio Macri allowed the currency to float freely and removed capital controls. In a two-minute televised address on that day, Macri said he had requested from the International Monetary Fund (IMF) an early release of funds from a $50 billion stand-by arrangement. The televised address did not help to eliminate market uncertainty. Instead, it made investors more jittery than ever, pushing the peso to its worst decline in almost three years.

On 30 August, Argentina's central bank raised its policy benchmark interest rate by 15 percentage points to a whopping 60% - the highest in the world - to stop investors from pulling money out of the country. This huge rate hike, however, failed to stem the peso's decline. The peso slumped a further 13% and closed at a record low of 39.2 per US dollar despite direct interventions by the central bank in the currency markets throughout the week to prop up its currency and bolster market confidence.

In 2018, the Argentine peso has depreciated by 51% against the dollar, making it the worst-performing emerging market currency this year.

IMF and Argentina: A rocky relationship

Argentina has had a troubled relationship with the IMF. Many Argentines blame the IMF for the policies that led to the 2001 financial crisis which triggered social unrest and political instability. In May 2018, Argentina sought financial assistance from the IMF amid a rapid depreciation of the peso. In June, the IMF Executive Board approved a three-year, $50 billion stand-by arrangement and the government immediately withdrew $15 billion from this facility. It is not yet disclosed how much money has been requested for early disbursement from the IMF, but market analysts believe that the Macri government is seeking at least $3 billion in September to calm investors' nerves.

Although the IMF has agreed to change the phasing of the financial programme, it is not yet clear whether any new conditions would be attached to the early release of funds. It is likely that the IMF will impose new austerity measures in exchange for the early disbursement. In a statement issued on 29 August, IMF Managing Director Christine Lagarde stated: 'I have instructed IMF staff to work with the Argentine authorities to strengthen the Fund-supported arrangement and to re-examine the phasing of the financial programme.' However, this statement did little to impress jittery investors, and the peso plunge continued.

Investors are increasingly concerned over the country's ability to meet dollar-denominated debt payments due next year. Argentina has about $25 billion of peso- and dollar-denominated debt payments coming due by the end of 2019. As the depreciation of the peso would lead to higher debt-servicing payments, investors fear that Argentina may not be able to meet its dollar-denominated debt obligations and could default.

Argentina's twin fiscal and current account deficits coupled with substantial foreign debt levels make its economy extremely vulnerable to tightening of global financial conditions. Additionally, agricultural exports (which contribute nearly 40% of the country's total exports) have been hit by the worst drought in 30 years. With high inflation (currently at 31%) and dim economic prospects, the peso is expected to remain weak for some time.

The impact of rate hikes on the domestic economy is already becoming visible as higher financing costs have led to a contraction of economic activity. The fiscal adjustments are also having an adverse impact on growth. The economy contracted 6.7% in June 2018 compared with the same month last year. There are strong fears that Argentina's economy is heading for a recession in the third quarter of this year. The government has recently admitted that poverty levels would rise this year because of high inflation.

In the coming days, the Macri government will find it challenging to implement stringent austerity measures further as elections are scheduled for October 2019. Any attempt to impose deeply unpopular austerity policies and economic reforms will further erode Macri's political capital and could dent his chances of winning re-election next year.

Argentina's ongoing currency turmoil is particularly worrisome as the government adopted orthodox economic policies often sought by the international investment community. The government dismantled interventionist policies; appointed market-friendly technocrats in the finance ministry; took a step towards a more independent central bank; raised interest rates to a record 60%; implemented painful austerity measures; and secured a $50 billion loan from the IMF. Yet, the country's currency troubles are far from over. The peso is still losing value and the economy is headed towards a recession. It is amply clear that policy measures taken by the Macri government are not in line with investors' expectations.

The Argentine episode offers several valuable lessons to other emerging market economies (EMEs) that are facing similar financial fragilities. It illustrates that floating exchange rates do not always guarantee insulation from shocks in the exchange rate. More importantly, it has shown that the IMF's stand-by loan of $50 billion - the largest credit line in IMF history - utterly failed to provide an effective anchor for addressing financial vulnerabilities and bolstering market confidence.

A very familiar crisis in Turkey

Meanwhile the Turkish lira has depreciated more than 40% against the US dollar since January 2018. Much of the recent steep fall in the lira's value is the result of a sharp deterioration in the US-Turkey relationship over the detention of an American pastor, but the economy's external position is extremely vulnerable due to massive borrowing in foreign currencies by the private sector and a debt-financed consumption boom.

Nearly 70% of Turkey's overall debt is denominated in dollars and euros. Taking advantage of lower interest rates globally, Turkish firms borrowed heavily in foreign currencies in the post-crisis period. According to JPMorgan, around $179 billion of Turkey's foreign debt matures between now and July 2019, out of which the private sector owes $146 billion (81%). A weak lira will make it harder for Turkish private firms to repay their foreign currency debts. If funds become scarce due to a sudden stop of capital flows to Turkey, the private sector will struggle to roll over its foreign currency debt.

The weakening of the lira also poses a refinancing risk to Turkish banks due to their excessive dependence on wholesale external funding (denominated in foreign currency) to fund lira-denominated loans in the country. A weak lira will make it much more expensive for Turkish banks to refinance their external market funding.

Besides, Turkey's lira crisis poses risks of wider contagion spreading to the European banking system as five big European banks (BBVA, UniCredit, ING, BNP Paribas and HSBC) have a sizeable presence in its domestic banking system or exposure to Turkey. According to cross-border banking data from the Bank for International Settlements, Turkish borrowers owe $82.3 billion to Spanish banks; $38.4 billion to French banks; $17 billion to Italian banks; and $19.2 billion to UK banks.

Declining foreign exchange reserves will make it difficult for Turkish authorities to finance the widening current account deficit (currently at 6% of GDP) or to arrest the slide of the lira by intervening in currency markets by selling dollars. Turkey had official reserves of $100 billion (foreign currency reserves of $77 billion and gold reserves of $22 billion) in July 2018.

Unlike Argentina, however, Turkey has not jacked up interest rates nor sought financial assistance from the IMF. The Turkish authorities have ruled out the imposition of capital controls to restrict outflows, but new restrictions were recently imposed on currency-swap transactions to curb short-selling against the lira. For liquidity support, Turkey has signed a $3 billion bilateral currency swap agreement with Qatar.

Challenges for Asian EMEs

A key policy concern is the threat of financial contagion from currency collapse in Argentina and Turkey to emerging markets in Asia. Argentina's currency turmoil has exacerbated the sell-off in currencies, equities, bonds and other financial assets in many Asian EMEs. Although Asia's economic fundamentals appear stronger than those of Argentina and Turkey, the currencies of India and Indonesia are currently trading at all-time lows.

The Indian rupee remains the worst-performing Asian currency this year. It has depreciated by 11% year to date. On 31 August, the rupee fell to a record low of 71 against the US dollar. Since April 2018, the fall in the rupee can be attributed to higher crude oil prices, the rising dollar, and concerns over the current account deficit widening to 2.8% of GDP in 2018-19. Besides, the market expectations of rising interest rates in the US, the consistent outflow of foreign funds and growing global trade tensions have also contributed to the weakening of the rupee.

The Indonesian rupiah is the second-worst-performing Asian currency this year, after the rupee. It has depreciated 7.8% this year. Spooked by the Argentine peso crash, the rupiah plunged to 14,750 per dollar - the lowest level since the Asian financial crisis of 1998 - even though the Indonesian central bank has been selling billions of dollars from its forex reserves kitty to stem the fall. It has also raised interest rates four times since May.

The widening current account deficit remains one of the key concerns for Indonesia. While the rupiah is continuing to weaken, Indonesia's bond markets have also come under selling pressure as the foreign ownership of government bonds is very high. Foreigners hold about 40% of the government bond market in Indonesia.

The Chinese yuan meanwhile has fallen more than 8% against the dollar amid fears of a trade dispute with the US, rising US interest rates and concerns over an economic slowdown in the domestic economy. Back in 2015-16, the Chinese authorities spent nearly a trillion dollars from the country's forex reserves to stabilise the currency. However, this time the authorities are shying away from direct interventions in the currency markets. The current policy response is directed towards using regulatory tools such as raising the reserve requirement ratio on foreign-exchange forward contracts from zero to 20% in order to make it more expensive to short the yuan.

The importance of capital controls and macroprudential tools

Maintaining financial stability is a big policy challenge for all EMEs. The recent episodes of financial crisis have amply shown that even those countries that followed seemingly sound macroeconomic policies also got exposed to 'sudden stops' or large reversals in capital flows. Hence the moot question is: How should emerging-economy policymakers respond to prevent rapid currency depreciation and a sudden reversal in capital flows?

To begin with, EME policymakers should proactively enforce capital controls to stem the risks of rapid capital outflows. The orthodox view is that capital controls do more harm than good. Critics question the effectiveness of capital controls, especially on outflows. Despite the negative connotation associated with the word 'controls', there are many positive experiences of using controls on outflows as a crisis management tool. This long list includes Malaysia in 1998, Iceland in 2008, Cyprus in 2013 and China in 2016.

EME policymakers can impose controls on both inflows and outflows of capital to insulate themselves from external shocks as well as to provide some breathing space to address longer-term structural problems. Controls on inflows can be helpful in altering their composition in favour of less risky and longer-maturity flows. Brazil is a well-known case in point. During 2009-11, Brazil adopted a series of capital controls (including a tax on portfolio investments) to discourage inflows to combat the appreciation of the real.

Rather than being used as a last resort and on a temporary basis, capital controls should have a place in the standard policy toolkit and could be deployed by EMEs keeping in mind their specific policy frameworks and country contexts.

Given the prevailing adverse market conditions, policymakers in Argentina and Turkey should shun their rigid stance against capital controls and adopt a pragmatic approach towards managing destabilising capital flows. The decision making in a complex, uncertain and financially interconnected world should not be driven by outdated neoliberal orthodoxy.

In parallel, EME policymakers should also impose macroprudential policy measures (such as caps on foreign currency lending, credit controls, and countercyclical capital requirements) for containing financial boom-and-bust cycles.

It is well recognised that policy interventions are more warranted during the boom period to limit the buildup of risk in the financial system. In this regard, it is desirable to use both capital controls and macroprudential measures in an emerging economy facing a surge of capital inflows ('sudden floods'). EME policymakers can choose the optimal mix of capital controls and macroprudential measures in mitigating currency and financial risks.

In addition, policymakers need to stay extra-vigilant about corporate debt issued in foreign currencies by non-financial corporations due to the potential risks associated with twin currency and maturity mismatches. Overall, there is a greater need for improving financial regulation and market surveillance in EMEs.

In the medium to long run, policymakers in EMEs should concentrate on attracting long-term capital flows that improve the country's productive capacity through the transfer of technology and managerial know-how, rather than short-term volatile capital flows (such as bank lending and portfolio investments) that have tenuous linkage with the real economy and are prone to abrupt reversals. The role of short-term portfolio flows in causing or exacerbating financial crises in many EMEs is well documented.

It is high time that EME policymakers rethink their approach towards global financial integration. Previous experiences of financial liberalisation (especially capital account liberalisation) in many EMEs have proved to be costly and exposed them to financial crises of various kinds, while the actual benefits of capital account liberalisation are hard to find. In particular, the liberalisation of short-term capital flows should be avoided.

The need for international cooperation

There is no denying that EME policymakers should adopt sound domestic policies and improve macroeconomic fundamentals, but it may not be sufficient to withstand financial shocks that EMEs are currently facing from spillovers of monetary policy normalisation in the US and other advanced economies. Hence, there is a need for global policy coordination. The advanced economies should also realise this need as increased financial market volatility can generate significant spillback effects on their economies.

Post-crisis, the importance of a global financial safety net has been well recognised. In this regard, bilateral swap agreements and regional financing arrangements (such as the Chiang Mai Initiative and the BRICS Contingent Reserve Arrangement) can be useful in providing immediate liquidity support when a crisis hits a country.

International policy cooperation is vital for managing volatile cross-border capital flows that can create financial fragility in the EMEs. Apart from imposing capital controls within the recipient countries, there is a logical reason for imposing capital account restrictions in the source countries to manage destabilising capital flows at both ends. Although the prospects of such a cooperative multilateral approach remain bleak, its potential benefits for global financial stability are enormous.

So far the G20 grouping of major economies has proved to be ineffective in developing a collective response to manage policy spillovers and spillbacks. As financial risks are likely to amplify in the coming months, it is critical that all G20 members cooperate to identify and manage risks collectively. Otherwise, what's the point of the G20 harping about promoting global financial stability?                                         

Kavaljit Singh works with Madhyam, an independent non-profit organisation based in New Delhi devoted to research and public education on economic and developmental issues. The above was first published as a Madhyam briefing paper available on

*Third World Resurgence No. 331/332, March/April 2018, pp 35-38