

Editor’s Note: This report was written by members of the Committee on International Economic Policy and Reform, a non-partisan, independent group of experts, comprised of academics and former government and central bank officials.



During 1999-2007, the international balance sheets of emerging economies grew stronger through

a combination of current account surpluses, a shift from debt funding to equity funding, and the

stockpiling of liquid foreign reserves. This risk-mitigating strategy improved the international

financial standing of many emerging economies and helped these economies withstand the 2008-

2009 global financial crisis.

However, a combination of domestic and external factors has led to a partial reversal of this strategy,

with some emerging economies accumulating significant external debt since 2010. Previewed

by the May 2013 “taper tantrum,” there has been considerable speculation that a tightening of

dollar-funding conditions and a macroeconomic slowdown in emerging economies may result in

financial instability in some emerging economies.

The risk of a global shock to international funding conditions is extensively documented. In view

of the central role of the dollar in international funding markets, global financial conditions are

significantly influenced by the stance of U.S. monetary policy. In particular, it is now widely accepted

that the federal funds rate plays an important role in determining the availability of dollar

funding.

In related fashion, and as recent experience with international spillovers suggests, the withdrawal

of quantitative easing by the Federal Reserve could be associated with tighter funding conditions

for international borrowers globally. If this is the case, the impact could be felt most acutely in

those emerging economies with the deepest financial markets and the poorest economic fundamentals.

The effect might come both from the quantity and the price sides since there might be a

tighter supply of dollars but, at the same time, the cost of borrowing might increase in local currency

terms. In addition, in terms of valuation effects, expected dollar appreciation will increase

the value of dollar debt, as has been witnessed during the course of the past year, where the real

burden of dollar-denominated debt has increased in emerging markets.

In addition to the shift in dollar-funding conditions, macro-financial fundamentals have deteriorated

in a number of emerging economies since 2007. Current account balances have declined

and foreign debt levels have increased. Credit growth has increased and leverage for some sectors (including the corporate sector) has climbed. Simultaneously, forecasts of potential output

growth have been revised downward, and the drop in commodity prices has damaged the income

prospects of commodity exporters.

The scale, composition, and volatility of international financial flows are a clear concern for policymakers

in emerging economies. Through a variety of channels, a reversal in international financial

flows risks destabilizing their domestic financial markets and the real sectors. Countries

running high current account deficits are particularly vulnerable to such reversals, facing the risk

of a traditional sudden stop. But those with large outstanding stocks of debt liabilities in foreign

currency could be vulnerable as well, facing both rollover risk and risks to their financial terms of

trade.

Looking at international balance sheets, the traditional focus has been on the cross-border positions

of banks and sovereigns. While these can be (and have been) sources of shocks, they are also

amplification mechanisms for the difficulties emanating in the real sector. As we have seen on a

number of occasions, a systemic financial disruption can have its origin in the strains on balance

sheets in the nonfinancial and household sectors.

The (direct and indirect) international financial positions of nonfinancial firms have been drawing

increasing attention. Large corporates can directly obtain funding from international banks,

the international bond market, and non-bank intermediaries, while small firms borrow from their

own banks in foreign currency terms. Indirectly, the corporate sector may induce financial inflows

by borrowing from the domestic financial sector that, in turn, obtains external funding. The foreign

currency debt obligations of the corporate sector are of particular concern, whether owed to

foreign creditors or domestic lenders.



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