COVID-19 a liquidity shock for emerging economies: Natixis

May 28, 2020

HONG KONG - The global financial group Natixis says the spread of COVID-19 to emerging economies has brought to light a reality that had been mostly forgotten in an era of ample dollar liquidity, namely, their excessive dependence on external financing. Amid the COVID-19 shock, foreign investors have left these markets at an unprecedented speed, resulting in a sudden global dollar shortage in March, Natixis says.

"Emerging markets depend on foreign capital and income through both capital and income channels. The former reflects the net borrowing through capital inflows," the Natixis report says.

"The more emerging markets rely on short-term portfolio inflows or 'hot money', the greater their exposure to global dollar liquidity shortages.

"The income channel consists mostly of the net exports or remittances. A shock like COVID-19 sharply reduces emerging markets' access to dollars, exports, tourism receipts, and even remittances, likely even to a larger extent than to advanced economies.

"The sudden stop in portfolio flows into emerging economies has also been unprecedented. In fact, the size of portfolio outflows is several times bigger than that of 2008, the 2013 Fed tantrum, or the China scare in 2015.  

"Against such a backdrop, the IMF estimates the total gross financing need of emerging markets could be as much as US$2.5 trillion."

Natixis says a good part of these needs is concentrated in a few systemic emerging markets which have long maintained market access. and are suffering most from the sudden stop in capital inflows.

"This is especially worrisome in countries with larger external debt to serve," it says.

"In light of policy tools that emerging markets can count on to address this challenge, the first line of defense - namely, using a country's monetary policy room to support growth - is becoming ineffective as investors shy away from weak currencies.

"Capital controls could provide a temporary relief, but are costly as they would imply losing access to foreign funding altogether.

"Self-insurance and regional insurance schemes are an option for a select few, especially in Asia, but the duration and depth of the shock is uncertain, which justifies exploring other potential options.

"The Fed has been quite fast in providing cross-border dollar liquidity, but its risks been overburdened due to massive domestic needs."

Natixis says the IMF continues to be the most obvious - albeit constrained - lender of last resort.

"Two changes are urgently needed for the Fund to be more effective," it says.

"The first is a more targetted set of liquidity facilities with quicker disbursement and less conditionality.

"Second, further recapitalisation is a must, but the options being discussed, including a new SDR allocation or a quota reform, will take time.

"Meanwhile, the recently-approved New Arrangements to Borrow (NAB) needs to result in actual disbursement by creditors. A rethinking of the timeline for Bilateral Arrangements to Borrow (BBs) is also urgent."

www.natixis.com (ATI).