Domino effect: how global market turmoil could trip emerging market banks

We’re all coupled. And in so many ways.

For proof, look no further than a new working paper that reinforces the notion the fortunes of emerging markets are greatly dependent on what happens in the global financial markets.

According to a paper by the Bank for International Settlements,  the link between emerging markets and global financial markets in particular, international bond markets — has the potential to destablise a country’s banking system.

The paper titled “The global long-term interest rate, financial risks and policy choices in EMEs” by Philip Turner notes that in the aftermath of the global financial crisis, easy money and ultra-low interest rates have led emerging market borrowers to increase their reliance on international bonds for their financing needs, which, in turn, has reduced their dependence on bank funding.

However, this phenomenon still leaves the banking systems of emerging market borrowers in a vulnerable position.

Take a look at the table below.

externalfinance

During the past three and a half years (2010 to the mid-2013), emerging market borrowers (corporate and non-corporate) have raise about $990 billion on the international bond markets. Non-banks accounted for more than $700 billion.

Notably, the value of bonds raised bynon-bank entities is twice as large as the value of cross-border lending by international banks.

Turner notes that along with higher international bond issuances, emerging market corporations have also acquired assets on a large scale.

What effect do  these developments have on the banking systems of emerging markets?

The reliance on global bond markets affect a country’s domestic banking system in three ways:

The first effect arises because EM (emerging market) corporations have typically borrowed from local banks.

“When extremely easy external financing conditions allow such firms to borrow cheaply from abroad, local banks have to look for other customers,” the paper notes. That means domestic lending conditions for local borrowers is actually easier than the actual numbers on bank credit suggest.

Conversely, if global monetary conditions tighten, larger companies that used to access global bond markets could ‘crowd out’  the small ones in the competition for funds. That will reduce the access to funds for smaller companies, even when local monetary policy has not changed.

The second channel works through the wholesale funding markets for banks. “When EM corporations are awash with cash thanks to easy external financing conditions, they will increase their wholesale deposits with local banks,” the paper says.

But such deposits are fickle and turbulent global conditions will lead to a flight of funds out of the country, making it difficult for banks to access such deposits easily during periods of international market turmoil.

The third link is through the hedging of their forex or maturity exposures, often via derivative contracts with local banks. Even if the local banks hedge their forex exposures with banks overseas, they still face the risk that local corporations will not be able to meet their side of the contract.

Effects on monetary policy

These effects, in turn, have an impact on central banks and how they manage policy.

“As a result of these linkages, the central bank may face greater instability in its domestic interbank market whenever large corporations find it harder to finance themselves abroad,” the paper notes.

“This can arise even if domestic macroeconomic conditions have not changed. The central bank that enjoys credibility could of course use local monetary policy to offset such destabilising forces.

“It could use its policy rate to resist any incipient rise in local money market rates; and it could relax its liquidity policies. But if corporate exposures are very large, the central bank may find itself contemplating measures of a scale or nature that might undermine its credibility,” it adds.

The paper argues that movements in US long-term interest rates, the global benchmark, can have major implications for both monetary policy and financial stability in emerging market economies.

“Downward pressures on some EM currencies could be accentuated, increasing the local currency cost of servicing dollar debt.

“Higher long-term rates, currency depreciation and more volatile markets could make even more difficult the choices that EM central banks face on their policy rate, on the exchange rate, on the long-term interest rate and on the best use of their balance sheet,” the paper argues.

For access to the entire paper, click here.

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