Credit crunch exposes emerging market deficit worries - analysis


As the credit crunch bites, investors are increasingly nervous over emerging market countries with large current account deficits, fearing they may follow Iceland into financial crisis and currency freefall.

Despite the ferocity of the banking and credit crisis in the United States and Europe, analysts have routinely touted the relatively subdued private sector debt levels and growth dynamics of emerging economies as factors helping many of them weather the worst of the storm. But as western investment capital abroad has turned sharply risk averse, it has also tended to retreat home. And that ebb of the money tide has exposed many countries most dependent on foreign finance to balance their national accounts. The extent to which this mobile capital is shunning particular countries or merely rotating between different asset classes and regions during a temporary hiatus in western banking is now central to the outlook.

“Iceland is the country that is probably seen as most affected,” said Fitch head of Eastern European sovereign ratings Edward Parker. “But countries with large current account deficits are likely to find it more difficult to find finance with a global credit crunch particularly in the financial sector.” Because its highly indebted banking sector leaves it more exposed than most to the global credit drought that arose from problems in the US mortgage market, Iceland saw its crown currency slump 20% in March. Its central bank has hiked interest rates to a record 15% to defend the currency even as firms, such as Fitch warned such action risked pushing itself into recession.

Ultimately, analysts say Iceland -- which tops the United Nations table for human development indicators measuring quality of life for its 300,000 inhabitants -- still has fundamental economic strengths and may in time recover. That doesn’t stop investors worrying over other countries with current account deficits close to Iceland’s 16% of GDP in 2007. “We don’t see any direct contagion from Iceland spreading,” said Michael Gaske, head of emerging markets research at Commerzbank.  “But there is an issue of sentiment. A current-account deficit isn’t a problem as long as you can cover it. But obviously if you have a panic situation people look at the big numbers.”


Those numbers have begun to look uncomfortable for markets in the Baltic states, Turkey, Bulgaria, Romania, Georgia and South Africa, which almost all have current-account deficits of between 7 and 25%. That has already impacted their currencies, with South Africa’s rand down 15% so far this year and Turkey’s lira down 11%. Turkey’s current-account deficit rose 28% year-on-year in January.

Analysts say some eastern European markets, such as those in the Baltics have had their current account deficits increased by capital flows between local banks and their Western parents. This distorts figures and so these countries may be less vulnerable than they look. Others such as Turkey are seen as having relatively stable foreign direct investment covering the gap, whereas South Africa is mainly reliant on equity flows that could easily be reversed and replaced by sudden portfolio flight. Another country often compared to Iceland is Kazakhstan, which has a lower current-account deficit of around 5%, but whose massively leveraged banks have also been under pressure and bailed out by the state.

But Kazakhstan’s oil and gas revenues -- with more on the way from further development soon to come on stream -- has left investors hoping it can look after itself. With central banks in the world’s largest economies still cutting rates to try and retain growth and avoid recession, some investors say they are not yet too worried about wide deficits. But they are still keeping an eye.


“If you talk about a view that is one month ahead I’m not worried about current account deficits,” said Ralph Sueppel, head of economics and strategy at Bluecrest Capital. “If you are talking about a longer term view once policy in the UK and other countries turned to tightening again it will be a problem -- but that is not a conversation to have yet but in six months or so.” The worries are actively benefiting countries with smaller current account deficit or surpluses, such as Poland and the Czech Republic, with their currencies rising around 3 and 6% respectively so far this year even against a stronger euro.

Troubles and worries over once perceived unassailable Wall Street powerhouses such as Bear Stearns has upended traditional views on what was safe and what was risky, with bank Lehman Brothers’ debt suddenly priced as riskier than Nigeria’s. “What you are seeing in the financial sector worldwide is a repricing of credit risk,” said Commerzbank’s Gaske. “It is a unique situation and it is difficult to price properly. If you are going into credit risk I would rather go into emerging markets than developed credit risk.” (Reuters)

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