External Debt Private Sector Debt Drives Broad-Based Build-Up of Emerging Markets External Vulnerability Risks

Following the painful experience of the Asian financial crisis of 1997-98, the Russian crisis of 1998-99 and the Argentinean crisis of 2001-02, external risks receded in most emerging market countries for several years. Strong economic growth and the increase in foreign exchange revenues resulting from the commodity super-cycle were accompanied by improved macroeconomic management, strong build-up of foreign exchange reserves, and lengthening of debt maturities. In addition, the deepening of domestic debt markets allowed governments to rebalance their funding towards local currency debt, further decreasing external vulnerability.

Post-2011, this trend has reversed and external vulnerability risks are now on the rise:

 

External vulnerability has increased significantly in about 75% of emerging economies globally

External debt has almost tripled in the last decade and over the last five years has generally grown faster than GDP and foreign exchange reserves. As a result, the average emerging markets external debt to GDP ratio increased from its decade-low of 40% in 2008 to 54% in 2015, and the average external debt to reserves ratio rose from 251% in 2007 to 353% in 2015. This is despite a slowing of the external debt growth rate from 14.2% a year during 2006-2010 to 7.1% a year during 2011-2015.

The rise in external debt has stemmed mainly from the private sector

Since 2005, private sector external debt has grown at an annual rate of 14.3% compared to 5.9% growth rate for public sector debt. As a result, the share of private sector debt in total external debt has risen from 51% in 2005 to 68% in 2015.

Vulnerability differs by region

Emerging Europe remains the region with the highest external vulnerability, followed by Latin America and the Caribbean and Asia Pacific. The Middle East and Africa region on average has the lowest external vulnerability.

The Asia ex-China region experienced the largest change over the last five years

For a decade, Asia had significantly lower external vulnerability metrics than the other regions, characterized by both lower levels of external debt and higher reserve holdings. That advantage has now disappeared, with the average external vulnerability of the Asia ex-China region being close to that of Latin America, although developments differ by country.

As of end-2015, emerging markets vulnerability to external debt crises is still less than in the early 2000s

Despite the deterioration in the past five years, average external vulnerability ratios as of 2015 are still around their 2005 levels: the average external debt to GDP across the 83 countries in our sample was at 54% in 2015 compared to 49% in 2005, average external debt to reserves was at 353% in 2015 compared to 348% in 2005, and the average External Vulnerability Indicator (EVI)1 was at 78% in 2015 compared to 91% in 2005.

Further, several macroeconomic factors are better-positioned than during the crises of the end-1990s

Most emerging markets today have flexible exchange rate regimes versus the currency pegs of the past. Inflation pressures are better contained, monetary policy is generally considered more successful in managing shocks, and banking systems are generally healthier. Local capital markets are deeper and better developed in a number of countries and can provide more of a cushion in the event of nonresident investor withdrawal. Finally, sovereign balance sheets in many countries are healthier and less-dependent on external financing than in the late 1990s. It is these factors that are contributing to the current resiliency of emerging markets to the post-2010 slow-down in net capital inflows, which the IMF estimates to be of the size and breadth of the major capital inflow slow-downs of the 1980s and 1990s.

However, going forward, many of the challenges will persist or exacerbate

Economic growth will remain sluggish for the medium term. We expect commodity prices to remain low for several years going forward, which will affect foreign exchange revenues and reserve accumulation in commodity exporters. US interest rates will continue towards normalization, albeit on a very gradual path, which could put further pressure on emerging market currencies. Finally, if continued, the slowdown in capital flows to emerging markets and tightening liquidity would lead to shortening of debt maturities and thus an increase in the proportion of short-term debt. All of these forces will lead to continued deterioration in external vulnerability metrics, and if prolonged, eventually to increased systemic crisis susceptibility.

Further, the fact that private sector external debt is now much larger than government debt not only increases external vulnerability risk but also the potential for materialization of contingent liabilities for the sovereign - an example of which is the current support of sovereigns for stressed major oil-exporting companies.

Finally, while this report focuses exclusively on external debt, domestic debt in the state-owned and private sectors has grown dramatically as well in many countries recently and represents additional financial risks in an environment of low growth, rising interest rates, and low commodity prices. It also represents additional potential contingent liability for government balance sheets and a constraint on future growth if high leverage curbs corporate investment.

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