I read this article on Quartz and I thought ian was an instructive depiction of why we should be worried about the Emerging Market sell offs currently trending. The writer Matt Philips (the in line text in red is from Ugometrics) explains how the emerging market sell off can get worse. It’s a scary take and one hopes the world economy is quickly able to address the situation before it gets out of hand.
We’ve already said that to understand the dangers of the current sell-off in emerging markets, you need keep an eye on the corporate bond market. Companies in emerging markets have binged on borrowing in recent years, as super-low interest rates in large developed economies drove investors abroad in search of investments that offered a higher payoff (Diamond Bank, GTB, FBNH all sourced money from foreign markets in the last two years)
And then currencies in key emerging markets tanked (Just like we are seeing now $/N N170)
Now, in theory, this is a good thing: Conventional economic wisdom holds that when countries allow their currencies to rise and fall—a flexible exchange rate—the fluctuation actually helps cushion the economy from so-called “external shocks.” For example, when a currency falls in value against major trading partners, a country’s exports become cheaper for foreign buyers, giving the country’s export sector a leg up on the competition. (Nigeria unfortunately is a net importer as such doesn’t even get to benefit from this)
But there are downsides to flexible exchange rates too. For one thing, a currency depreciation makes debt denominated in a foreign currency tougher to repay. (If you need to pay your debt in dollars and dollars are more expensive, your debt just grew, too.) In order to repay it, borrowers have to cut spending on things like employees and new equipment. On a big enough scale, that undermines the health of the economy. (This will mostly affect banks and Companies that borrowed money overseas. Cutting spending on employees either through downsizing or payroll reduction can affect the economy negatively especially a re-emerging middle class like Nigeria. Cutting spending on equipment’s affect the ability of companies to fund new investments as which affects the wider economy)
There’s one other thing, too. The woes of the corporate sector could spill over into the banking system, which—as the Great Recession demonstrated—can be disastrous for growth. An interesting paper out today from the Bank for International Settlements, the Basel, Switzerland based “central bank of central banks,” lays out three possible ways the current emerging-market selloff could go from a nasty slump in the market to a problem for the banking systems in these countries:
1. Something rotten emerges in the banks
Explanation: Because emerging-market companies have been able to borrow so cheaply from foreign lenders, domestic banks had to find other customers. In other words, they had to lower their lending standards. A sharp run up in interest rates—which happens when central banks try to fight the currency slump by raising interest rates—could expose just how weak some of those borrowers were. (The CBN is currently fighting this by increasing Public CRR twice already. This in effect limits earning potential of banks and to plug that hole they will start to lend aggressively. Aggressive lending in turn can lead to poor loan quality and default)
2. The corporations start to pull their deposits
Explanation: As it gets more expensive for non-financial companies to borrow, they want to use their cash more. That means they take it out of the banks, where they’ve had it on deposit. That, in turn, makes it more expensive for banks to borrow, driving down profitability, and possibly making it tougher for them to fund themselves. (This is already happening in Nigeria as banks scramble to seek for deposits. This can also affects thousands of jobs and subsequently erode a fragile middle class)
3. Banks aren’t as well-hedged as they think
Explanation: “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.” Think of this as the AIG problem. Prior to the financial crisis, Wall Street’s banks all claimed their exposures to subprime assets were well-hedged—but many of them were hedged by derivatives contracts with the insurance giant AIG. When AIG itself reached the brink of failure, the insurance policies Wall Street bought were virtually worthless. No one knows if there’s a similar problem lurking in the emerging markets. There is no such thing as a full proof hedge. Prior to the banking crisis in 2009-2010 most banks posted astronomic profits even though corporations mostly posted losses. This anomaly was to come home to roost when close to half of the banks failed and were declared insolvent by the CBN. It became obvious the profits were mere paper profits.
While these scenarios may seem like an exercise in disaster planning, it’s worth thinking about. So-called “twins”—a combined currency and banking crises—have been found to be most common among financially open emerging-market economies.
Source: Quartz