The Coming Emerging Market Debt Squeeze

How vulnerable are emerging economies because of all this dollar debt? Optimists like to point out that emerging markets have accumulated a huge stock of international reserves since 2010, enabling them to self insure against a run on their currencies or their foreign debt.

By and large, experience supports this method. Indeed, the huge expansion in emerging market domestic debt issuance in recent years has helped reduce market tensions (though continuing reliance by corporates on foreign debt still leaves many countries vulnerable).

And the market is prone to temporary fits of shared enthusiasm for emerging market debt, for Internet stocks, for residential mortgage backed securities, for Greek government debt. Traders need not wait to see when or whether the profits materialize.

(c) An allocation to emerging market debt may be an optimal method of achieving exposure to the potentially high risk high return profile of developing countries

In countries that cannot issue debt in their own currency (traditionally emerging market economies), or that issue debt in their own currency but cannot independently print money (as in the euro zone), unsustainable fiscal deficits often lead to a credit crisis, a sovereign default, or other coercive form of public debt restructuring.

The shift favors hardline creditors in bond issuances governed by US law. With emerging market growth slowing, and external debt rising, new legal interpretations that make debt future write downs and reschedulings more difficult do not augur well for global financial stability.

This is how the Latin American debt crisis of the 1980s, the Mexican Tequila crisis of 1994, the Asian debt crisis of 1997, and the Russian crisis of 1998 unfolded. It was also how the financial crisis of 2008 2009 transmitted itself to emerging markets.

Subsequent programs to deal with emerging market crises featured an analogous combination of country adjustment and private sector involvement. Voluntary debt exchanges worked, roughly speaking, with investors accepting haircuts.

A voluntary code of conduct was also developed by the Institute of International Finance, which proposed the Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets.

Some sovereign debtors and private creditors have been attempting to develop voluntary Principles of stable capital flows and fair debt restructuring in emerging markets , but progress has been slow.

But, in large part and with a few exceptions in Central and Eastern Europe emerging market economies improved their fiscal performance by reducing overall deficits, running large primary surpluses, lowering their stock of public debt to GDP ratios, and reducing the currency and maturity mismatches in their public debt. As a result, sovereign risk today is a greater problem in advanced economies than in most emerging market economies.

The stumbling block has been potential investors fear that accounting fiascos in emerging countries would render the bonds unsafe. If you don t trust the numbers, you can t trust the debt.

Ironically, today s pain stems from one of the great successes that emerging economies have achieved the reduction of foreign currency funding in favor of local currency debt. As emerging market central banks leaned against heavy capital inflows in order to mitigate exchange rate appreciation, their currencies became less volatile.

SEOUL Emerging Asian countries should be proud of their economic resilience. Despite a global economy plagued by weak growth, persistently high unemployment, and heavy debt loads, the region s emerging and developing economies grew at an average annual rate of 6.8 from 2000 2010, propping up global output and buttressing recovery efforts.

Argentina may be almost as famous for its defaults as it is for its soccer teams, but it is hardly alone. Virtually every emerging market country has experienced recurrent sovereign debt problems.

The answer is to emulate the response to sovereign debt crises in Uruguay, Pakistan, Ukraine, and many other emerging market economies, where orderly exchange of old debt for new debt had three features an identical face value (so called par bonds) a long maturity (20 30 years) and interest set well below the currently unsustainable market rates and close to or below the original coupon.

There is no denying that advanced democracies largely failed to preempt the financial and sovereign debt crises, while most emerging economies pursued better economic policies. How can modern Western democracies impose strict fiscal discipline?

The call by some nations whose economies, like that of the Dominican Republic, can be considered as emerging, for a debt swap programme to help achieve the MDGs makes sense in such a context.

Debt sustainability and debt relief

Until the euro crisis, it was generally believed that problems servicing sovereign debt occurred only in emerging markets and the least developed countries. The US Supreme Court s decision on Argentina adds a new wrinkle, and may well further increase the risk attached to holding sovereign debt and this to the cost of issuing it.

Unfortunately, too many policymakers in advanced economies allowed themselves to believe that such heterodox policies are only for emerging markets. In fact, advanced countries have resorted to heterodox policies to reduce debt overhangs on many occasions.

Their cash balances are extremely high, interest payments on debt are low, and principal obligations have been termed out. Many of them are successfully tapping into buoyant demand in emerging economies, generating significant free cash flow.

Emerging issues

Some have thus called upon major emerging countries to step up and use their huge foreign exchange reserves to purchase the debt of crisis ravaged countries, such as Greece, Italy, and Spain. In particular, China, with its 3.2 trillion in foreign exchange reserves, is seen as a potential white knight coming to the rescue of debt ridden European nations.

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Introduction emerging trends

In the next few months, Europe s debt crisis will most likely worsen. With emerging economies (including China) slowing, and with meaningful multilateral policy coordination remaining inadequate, protectionist pressures will mount as major trading powers compete for a stagnant pie.

The emerging market boom already looks as if it is the next vision to be cast in the garbage can of history. The ratings agency Moody s is preparing warnings about the extent and quality of Indian private sector debt.

Most economists failed to foresee the economic dynamics that actually led to the crisis, because they failed to pay enough attention to the rapid increase in US total debt. Instead, they focused exclusively on US foreign debt, ignoring household debt (mortgage and consumer debt), public debt, business debt, and financial debt.

In the emerging world, however, the mismatch between growth expectations and actual potential has often become a serious issue that demand side stimulus and endless debt accumulation cannot cure. Rather, governments should stop basing their legitimacy on inflated growth prospects.

This brought strong growth rates in good times. In times of crisis it had a negative impact although integration has prevented currency collapse or the write off of national debt, occurrences that we have witnessed during previous crises in emerging markets.

But, as industrial countries, beset by fiscal, sovereign debt, and banking problems, slowed once again, the fix for emerging markets turned out to be only temporary. To offset the collapse in demand from industrial countries, they had stimulated domestic demand.

It's called Emerging Angel.

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