Moving into a Low Pressure Area? The Financial Sector Post-Crisis: Challenges and Vulnerabilities Brookings Institutions by Khalid Sheikh Head: Emerging Markets Analysis & Multilateral Organisations (EMA & MO) ABNAMRO Bank NV April 26-27, 2005

Emerging Markets Analysis & Multilateral Organisations  Benign environment  Need to recalibrate compass  Key risks to emerging markets  Perfect storm  Consequences Contents

Emerging Markets Analysis & Multilateral Organisations  Recovery in International Capital Flows  Improvement in Net Liability Positions  Diversification in maturity distribution Sovereign Debt  Credit Quality improved, reduced cost of capital  More Fiscal restraint and responsibility  Strong domestic investor base in Emerging economies  Higher Commodity Prices Benign Environment: Notion

Emerging Markets Analysis & Multilateral Organisations Performance outlook by Region +/N+Middle East/Africa +/N+Latin America ++ Asia N/-+/NJapan ++Emerging Europe N/-_Western Europe ++NAFTA Long-TermShort-Term

Emerging Markets Analysis & Multilateral Organisations Benign environment: Reality?  EMBI+ lost? Spreads DO NOT reflect real risks  “Herd mentality” doubts about loyalty of investors  On average debt ratios for EM still high compared to 1990s  Growing vulnerabilities to externalities  How sustainable is China’s growth?  What is Rational Behaviour ? Do Not assume policy makers to act rationally. No room for complacency

Emerging Markets Analysis & Multilateral Organisations EMBI+ lost?

Emerging Markets Analysis & Multilateral Organisations Trade finance by commercial banks, by investment rating, Percent of total bank lending Non-investment grade and non-rated Investment grade … and what about Ratings… Trade finance is a key source of finance for less creditworthy countries

Emerging Markets Analysis & Multilateral Organisations Need to Recalibrate Compass  Markets are risky  Trouble runs in streaks  Markets have a personality  Markets mislead  Market time is relative

Emerging Markets Analysis & Multilateral Organisations Financial flows sustainability to finance the US current account deficit  A further depreciation of the USD could increase the risk premium demanded by foreign investors on US assets.  This could lead to market volatility and a sharp increase in long-term bond yields.  This would increase the EMBI spreads even higher. The vulnerability of heavier indebted countries increases significantly in this scenario.

Emerging Markets Analysis & Multilateral Organisations

Emerging Markets Analysis & Multilateral Organisations However, we still expect an orderly adjustment of the USD  US remains pacesetter for global growth and innovation  USD remains an anchor currency  Other countries should therefore still be prepared/have no other choice to invest their excess savings in the US  Even if the USD would fall quite sharply, there are "automatic corrective factors": domestic US investors repatriating their foreign held assets due to changes in relative asset prices. Fed further increases interest rates, resulting in new investment inflows to the US

Emerging Markets Analysis & Multilateral Organisations Public finances are a key vulnerability for emerging markets going forward  Fiscal performance/discipline to generate primary surpluses: Turkey / Brazil and India / Philippines.  More debt issued in domestic markets and domestic currency with shorter maturities, which means that interest rate fluctuations can translate rapidly in debt service  For many countries, LCY real interest rates are the primary determinant of debt service. In some cases, inflationary pressures keeps interest rates very high.  Exchange rates and their path also matter.

Emerging Markets Analysis & Multilateral Organisations Public debt developments last 10 years

Emerging Markets Analysis & Multilateral Organisations Public debt developments last 5 years

Emerging Markets Analysis & Multilateral Organisations Public debt composition

Emerging Markets Analysis & Multilateral Organisations Anatomy of Financial Crises* * Origin of crisis could initiate from any particular point

Emerging Markets Analysis & Multilateral Organisations Renewed sharp increases in US current account deficit and related dollar crash 2.Oil prices structurally at USD 70 plus 3.Rising trade tensions 4.“Hard landing” in China 5.Globalisation is double-edged sword 6.More stringent Governance and Basel 2 could curtail the supply of resource flows Risks on the Horizon

Emerging Markets Analysis & Multilateral Organisations Impact

Emerging Markets Analysis & Multilateral Organisations A new round of Crises? given worrisome comparisons between the low pressures of the 1980s and the 2000s  World imbalances are bigger  Capital markets are bigger  Inflation is lower  World growth is more fragile –Germany and Japan cannot help  More countries have to be involved in the adjustment process  Little appetite for coordination

Emerging Markets Analysis & Multilateral Organisations New chain of sovereign crises? Asia July 1997 Russia August 1998 Brazil January 1999 Argentina December 2001 US 2005? China 2007/2008?