Emerging Markets : International reserve losses in the 2008-9 crisis a study

Emerging markets accumulated massive international reserves over the last decade. Economies that accumulated reserves for trade concerns drew them down in response to the shock, while economies driven by financial factors showed a “fear of depleting”.

Investigating the patterns of exchange rates, interest rates, and international reserves during 1970-1999, Calvo and Reinhart (2002) inferred the prevalence of the “fear of floating”. Countries that say they allow their exchange rate to float mostly do not. Instead, frequently the authorities are attempting to stabilise the exchange rate through direct intervention in the foreign exchange market and in open market operations. The fear of floating may also explain the massive hoarding of international reserves during the last ten years by emerging markets and other developing countries, though alternative explanations include the precautionary and/or mercantilist motives (Aizenman and Lee 2007, 2008), as well as the reincarnation of the Bretton Woods system (Dooley et al. 2004).

In recent research, we investigate the degree to which the fear of floating guided the adjustment of emerging markets to the unfolding global financial crisis (Aizenman and Yi 2009). This crisis presented daunting challenges to emerging markets – the “flight to quality,” deleveraging, and the rapid reduction of international trade began inmid-2008, testing their adjustment capabilities. While in many earlier crises, emerging markets were forced to adjust mostly via rapid exchange rate depreciation, the sizable hoarding of international reserves during the late 1990s and early 2000s provided these countries with a richer menu of choices. A prime concern of our study is the degree to which the large earlier hoarding of international reserves “paid off,” by allowing emerging markets to buffer their adjustment by drawing down their international reserves.

We investigate the adjustment of 21 emerging markets during the window of the crisis, and found a mixed and complex picture.¹ Figure 1 presents the countries’ monthly international reserves (IR), measured relative to their peak from January 2008 until February 2009. Regression analysis shows that emerging markets with a large primary commodity export, especially oil export, tended to experience large reserve losses in this global crisis. Countries with a medium level of financial openness and a large short-term debt ratio also lost on average more of their initial holdings. Most of the countries that suffered large international reserve losses started depleting them during the second half of 2008, and many have still not returned to pre-crisis levels.

Intriguingly, only about half of the emerging markets relied on significant depletion of their international reserves as part of the adjustment mechanism. We proceeded by dividing our sample into two groups: countries with sizable reserve losses, and countries that did not lose reserves or quickly recovered them. We define the first group as countries that lost at least 10% of their international reserves during the period of July 2008- February 2009, relative to their peak. Among 21 emerging markets, nine countries are in the first group.²

Figure 1. Emerging markets’ international reserves relative to peak holdings, Jan 2008 – Feb 2009

emerging markets

To gain further insight, we compare the pre-crisis demand for reserves as a share of GDP of countries that experienced sizable depletion of their holdings to that of countries that didn’t, and we find different patterns between the two groups. Trade-related factors (trade openness, primary goods export ratio, especially large oil export) seem to be much more significant in accounting for the pre-crisis reserve-to-GDP ratio of countries that experienced a sizable depletion of their reserves in the first phase of the crisis. These findings suggest that countries that internalised their large exposure to trade shocks before the crisis used their reserves as a buffer stock in the first phase of the crisis. Their reserves losses followed an inverted logistical curve – after a rapid initial depletion of reverses, they reached within seven months a markedly declining rate of reserve depletion, losing not more than one-third of their pre-crisis holdings. In contrast, for countries that refrained from a sizable depletion of their reserves during the first phase of the crisis, financial factors account more than trade factors in explaining their initial reserves-to-GDP level. The patterns of using reserves by the first group, and refraining from using reserves by the second group, are consistent with the “fear of losing reserves”. Such a fear may reflect a country’s concern that dwindling reserves may signal greater vulnerability, triggering a run on its remaining reserves. This fear is probably related to a country’s apprehension that, as the duration of the crisis in unknown, depleting international reserves too fast may be sub-optimal – it exposes the country to the risk of abrupt adjustment if the crisis turned out to be deeper and more enduring than it initially believed.

Our paper suggests that there exists a clear structural difference in the pre-crisis demand for international reserves between emerging markets that were willing versus those that were unwilling to spend a sizable share of their holdings during the first phase of the 2008-9 crisis. Trade-related factors are more significant in accounting for the pre-crisis reserve level of the countries that experienced a sizable depletion of their reserves in the first phase of the crisis, in line with the buffer stock interpretation of the demand for international reserves. Countries that depleted their reserves in the first phase of the crisis, refrained from drawing their reserves below one-third of the pre-crisis level, with the majority using less than one-quarter of their pre-crisis holdings. Countries whose pre-crisis demands for international reserves were more sensitive to financial factors refrained from using them altogether, preferring to adjust through larger depreciations. These patterns may reflect the fear that dwindling reserves may induce more destabilising speculative flows. Our results suggest that the adjustment of emerging markets during the on-going global liquidity crisis has been constrained more by their fear of losing international reserves than by their fear of floating.

These findings raise new questions. More work is needed to understand why countries differ in the weight assigned to financial versus commercial factors in accounting for their demand for reserves. Intriguingly, the average exchange rate depreciation rate from August 2008 to February 2009 was about 30% in both emerging markets that depleted their reserves and those that refrained. A hypothesis that can explain this observation is that the shocks affecting the emerging markets that opted to deplete their reserves were larger than the shocks impacting emerging markets that did not. Testing this possibility requires more data, not available presently, including the deleveraging pressures during the crisis. This hypothesis, if valid, implies that countries prefer to adjust to bad shocks first via exchange rate depreciation, supplementing it with partial depletion of their international reserves only when the shocks are deemed to be too large to be dealt only with exchange rate adjustments.

The fear of using reserves also suggests that some countries opt to revisit the gains from financial globalisation. Earlier research suggests that emerging markets that increased their financial integration during the 1990s-mid 2000s, hoarded reserves due to precautionary motives, as self-insurance against sudden stops and deleveraging crises. Yet, the crisis suggests that for this self-insurance to work, it may require levels of reserves comparable to a country’s external financial gross exposure (see Park (2009) analysing Korea’s challenges during the crisis). In these circumstances, countries may benefit by supplementing hoarding with Pigovian tax-cum-subsidy policies (Aizenman 2009). A possible interpretation for the fear of losing international reserves is the “keeping up with the Joneses’ reserves” motive – the apprehension of a country that reducing its reserves-to-GDP ratio below the average of its reference group might increase its vulnerability to deleveraging and sudden stops (see Cheung and Qian (2009) for such evidence from East Asia). These factors suggest a greater demand for regional pooling arrangements and swap lines, as well as possible new roles for International Financial Institutions. A better understanding of these issues is left for future research.

Original article by Joshua Aizenman, reproduced by kind permission of VOXEu

HSBC banking on BRIC & Emerging Markets

HSBC has reacted strongly to retail customer demand in New Zealand by launching four new funds, entirely focused on Emerging Markets. The four NZ$ denominated funds in which customers can invest are the China Fund, India Fund, BRIC Fund & the Asia ex Japan Fund. New Zealand investors have been looking for opportunities to take advantage of the phenomenal growth in emerging markets where we have seen EEM, EWZ, FXI & IFN realising returns between 41% – 70% year to date. These markets are widely acknowledged to be the fastest growing in the world.

“We are delighted to make this further investment in our business in New Zealand.” said New Zealand CEO, David Griffiths “This expansion of our offering also helps to further deepen our position within New Zealand.”

Last year, HSBC relaunched their Premier Banking service in order to offer Global Unit Trust products to retail investors in a number of territories. The strategy would seem to be paying off, as it allows customers to indulge in investing into new & emerging markets via the existing HSBC global network of 86 countries.

“We are excited to be a part of bringing the funds to New Zealand investors” said HSBC’s CEO Asia-Pacific Rudolf Apenbrink “providing them with the opportunity to invest in emerging markets that may typically be difficult to enter.”

The “broader reach” of HSBC would seem to be paying dividends for the bank when compared to its peers. Barclays Capital H1 2009 profits almost doubled to $1.35bn whilst HSBC Global Banking & Markets reported record H1 profits of $6.2bn against $2.7bn last year, an, encouraging seven fold increase on H2 2008. Asia contributed about 90 % of the group’s profit in the first half.

Meanwhile, HSBC is looking to be the first non-Chinese bank to gain a listing on the Shanghia stock exchange & has started the process for an IPO, timing is still unclear according to Vincent Cheng, Executive Director & Chairman for Asia-Pacific.

“Emerging markets’ contribution will account for about 60 % of the total after the U.S. market returns to profit. This is our target and, of course, we would not mind if the portion from emerging markets is bigger.”

As HSBC has a long history with & is inimically tied to Hong Kong, I can see it being able to achieve it’s aim, the choice of partner will remain open for some time. Amy successful IPO combined with the potential of Chinese retail investors to access HSBC’s global network, would have a massive impact on revenues & profitability. A big ask at the moment, but I for one will be placing a reasonable bet if & when the IPO gets clearance.

Vodafone steps up to the plate, backed up by Emerging Markets

Last week Vodafone Group (NYSE:VOD) released an interim management statement that considering the current economic climate, I consider to be pretty upbeat. I have been a long term holder of Vodafone stock on the London Stock Exchange & have over the last year traded the NYSE traded ADR up & down on swings. However with the current market, I am now looking for some growth & value plays. Looking a little closer at the report & doing some quick analysis of some of the major themes contained, I am now quite bullish on VOD going forward & will be picking up some shares for my investment portfolio. As of writing Vodafone was trading at £121.00 in London & $19.64 in New York.

Comment from : Vittorio Colao, Chief Executive

“In the first quarter the service revenue trend in Europe was consistent with the previous quarter and we continued to see good growth in India and South Africa. Our total communications strategy is delivering well, with organic data revenue up 19% and organic fixed line revenue 7% ahead of the comparative period. Free cash flow generation was strong at £1.9 billion, up 21%. The Group has reaffirmed its guidance for the full year.”

Highlights from the report :

• Group: Revenue £10,743 million, up 9.3%
• Group data revenue of £888 million, up 19.4% on an organic basis
• Free cash flow of £1,896 million, up 21.2%; net debt at 30 June 2009 of £31.2 billion
• Cost reduction programme on track
• Proportionate mobile customer base of 315.3 million; 8.0 million net additions during the quarter

• Europe: Service revenue up 4.4% driven by FX benefits. Data revenue up 17.8%. Fixed line revenue up 5.7%
• Africa & CEE: Service revenue up 26.3% including Vodacom acquisition,Vodacom organic growth of 5.2% offset by weakness in CEE
• Asia Pacific and Middle East: Service revenue up 21.8%
• India service revenue growth of 23.0%

Interesting to see Vodafone making a point of mobile data revenues & 19.4% grwoth is a pretty impressive statistic. Much of this being driven out of Europe, where one of the big booms in mobile data is the popularity of 3G wireless broadband dongles (USB sticks) on “Unlimited” packages, which all the major operators have adopted. Vittorio Collao announced a major cost cutting initiative last November 2008, targetting cost reductions of $1.45Bn by  the end of the 2011 financial year in order to offset the pressures from inflation and the competitive environment and to enable investment in revenue growth opportunities. Savings of more than 65% of this target are expected to be generated by the end of the current financial year.

Vodafone has been at the forefront of network sharing, originally this started in the UK with Orange, now the group has signed a pan-European deal with Telefonica-O2, which will see network sharing being implemented in Germany, Ireland, UK & Spain. Analysts see this as a huge positive, as the deal is set for a ten year term & should save each company in the region of $350 million per annum. The growth figure of 8 million subscribers runs in line with analysts global forecasts for 2009 of circa 13%, as Vodafone is one of the higher value operators in each of its markets, the fact that it is expanding subscribers in a high churn market is positive.

“Old” Europe is the only area where Vodafone operates both fixed & mobile services, predominantly in the UK, Ireland, Spain, Potugal & Germany, where it is the second largest provider of broadband via its Arcor business unit. Having already discussed the cost savings initiative with Telefonica, the main story here is on how Vodafone are manbaging to reduce churn & promote ARPU via new services. Vodafone is far & away the leader in all of these markets regards business services (excepting Germany, which is dominated by T-Mobile), with consumer playing a strong supporting role, crucially the majority of these accounts are postpaid, which is reflected in higher service revenues than is the norm in this sector.

Another area that Vodafone is finally catching onto is the machine-to-machine market, or M2M. The company has made some recent investments in this sector & is set to benefit as the market grows from $4.2Bn in 2008, forecast to rise to $12.5Bn by 2012. It’s not all good upbeat news though, as recent EU intervention in roaming charges has had a detrimental effect on voice service revenues aceross the board. Retail termination costs have hit this part of the business very hard, with only Netherlands showing minimal growth of 0.6% mainly due to MVNO operations, whilst at the other end of the scale, Greece voice revenues sank by 15%.

In “new” Europe (CEE) & Africa, the atypical Emerging Markets,  we are presented with a mixed bag, however the region saw service reveues grow by 26.5%, mainly due to Vodacom (of which more later). Vodafone has seen serious competition in Romania, where no less than 6 operators are competing for one of the lowest ARPU generating populations in Europe, the situation not being helped by the extremely poor performance of the Lei versus the Euro. Similarly, Turkey has not been the shining star that Vodafone had expected when it launched their in 2005. However, now that 3G services are finally being launched, Collao today announced that the company would be investing up to $675 million in network infrastructure over the next 12 months, as Turkey has very low fixed line connections, mobile broadband is set to be a revenue enegine. I also have a feeling that as & when Turkey accedes to the EU, plenty of “rural” grant funding will be made available for the three network operators to provide near 100% coverage. At time of writing, there are some rumours of Turkcel & Vodafone entering into limited network sharing on 2G (GPRS) services, but these remain unconfirmed.

Meanwhile, Africa has seen a real boost this year, with Vodafone finally acquiring a majority interest in Vodacom South Africa from Telkom, as we discussed earlier this year in Consolidation hits Rainbow Nations telecom sector; Vodacom is now the flagship Vodafone brand in sub-Saharan Africa & has recently listed on the Johannesburg Stock Exchange. Another hit in this region is Vodafone’s 40% majority holding in Kenya’s Safaricom. Jointly the two companies launched the mobile payment platform M-Pesa back in 2007 & it has gome through a number of modifications & upgrades since then, winning a United Nations award along the way. The service has 5.75 million users signed up in Kenya & now that it has been proved & tested, look to Vodafone to launch M-Pesa in a number of new regions in Africa, such as Nigeria, Ghana & South Africa. An interesting video on Safaricom & M-Pesa can be viewed here : Michael Joseph

Vodafone’s controversial investment in Essar , seems to be paying off handsomely, as the Indian carrier now operates in all 26 mobile circles across the sub-continet. Service revenues jumped by 23% with the subscriber base leaping 56%, or  by 77 million subscribers in the last year. Vodafone will also be launching M-Pesa in India this year & it is thought that up to 17% of the subscriber base will ustilese the m-payment system. Vodafone-Essar recently applied & was granted both a national Internet Service Provider & National Long Distance licences, from the Indian Government, as expectations run high on the “last mile” being finally opened. The NLD licence will have an immediate effect, as Vodafone will now be able to backhaul its own national STD voice traffic & not have to rely on local carriers, which will be a welcome development since mobile voice terminations have fallen by 5% in India in the last year.

In Asia Pacific, there is only one big story & that is the merging of Vodafone Australia & Hutchinson Whampoa’s 3 in order to create a realistic competitor to government owned Telstra. The new Vodafone-Hutchinson Australia is a 50-50 JV, which will carry the Vodafone brand & now has a combined cutomer base of just over 6 million users. Vodafone will be looking to leverage its Vodafone Live! content platform here & significant cost savings on network (roaming charges) can be expected, the combined networks now have 98% coverage of metropolitan areas across the country. Vodafone will also receive a deferred payment of AU$500 million from Hutchison-Whampoa, to reflect the difference in the joint business assets (network).

So all in all, a home run for Vodafone in its first quarter of the current financial year. Considering the global economic environment, I feel that this is a great performance (although possibly helped along by currency rates) & that if the management team can keep a firm grip on the operating companies, Vodafone should be one of the strongest performing telecoms companies for 2009-2010. Continued expansion in both India & Africa, along with the introduction of services such as M-Pesa will attract & hold valuable customers. I’m long on the ADR, having bought in last week at $18.68 & am looking for it to exceed $23.50 within three months.

Swedbank opens kimono on Baltic Lending … not a pretty sight

Swedbank, Sweden’s fourth largest lender & one of the biggest banks in the Baltic region, revealed the full scale of Swedish exposure to economic turmoil in Eastern Europe last week. The bank posted dismal figures due to large losses on loans made to firms in the troubled Baltic region.

Swedbank was the first in a series of Swedish and other Nordic banks scheduled to announce results in coming days as the region’s lenders count the cost of aggressive expansion in Latvia, Lithuania and Estonia. Nordic banks piled into the former Soviet states after their entry into the European Union in 2004 and initially prospered from rapid growth in the region.

The bank revealed a surge in bad loans from the Baltic States and Ukraine. Investors were reassured by the bank’s insistence that it could weather the storm without raising fresh capital, pushing the stock up more than 11 % after a day of volatile trading. At the same time, it announced that it would slash 16% of its workforce. However, it closed on Friday up 21.5% as investors were reassured that it would not raise extra capital.

The worse-than-expected second-quarter losses show that Sweden’s banking sector is still facing a barrage of bad loans from the Baltic States, even as the country is hailed as a financial role model after its recovery from a banking crisis in the 1990s. Bank’s aggressive lending has backfired in recent months as the Baltic economies have plunged deeper into recession than anywhere else in the EU.

Swedbank, the largest lender in the Baltics, posted net losses of SKr 2, 01bn ($257m), compared with net profits of SKr 3,6 bn a year earlier. It was the bank’s second consecutive quarterly loss and much worse than the SKr 1,27 bn deficit forecast by analysts. Loan losses soared from SKr 423 mln a year ago to SKr 6,67 bn, with about two-thirds of the amount in the Baltic States and a third in Ukraine. In response, the bank said it planned to reduce staff by 3,600, about 16 % of its workforce, by this time next year, with most of the cutbacks in the Baltic States.

“The most recent quarter has been marred by continued uncertainty about the future of the economy,” the bank’s Chief Executive, Michael Wolf, said in a statement. “The recession is now making itself more visible, and all signs are that the downward trend will continue for some time.”

Faced with mounting losses on loans in recession-hit economies, where bad loans have shot to highs of 18% of total lending in Latvia and 24% in Ukraine, Swedbank is trying to cut costs and lower its risk profile to secure funding and ride out the storm. Swedbank will continue to close branches and increase staff cuts as it takes a defensive stance, in anticipation of further economic hardship in the region, having followed a more aggressive path of expansion, the bank will be returning to more traditional practices.

“We are taking the necessary steps to right-size business units to reflect the lower economic activity in the banking sector as a whole,”  said Wolf  “We expect impaired loans to increase in the second half but it will be less than in the first half”

The negative results came after a mission from the International Monetary Fund visited Latvia recently in order to negotiate the release of a € 200 mln ($283m) tranche of a €7.5bn emergency loan agreed late last year. The IMF has held back the funds while it seeks commitments from the Latvian government over structural reforms, increasing nervousness that the rescue package could unravel.

Swedbank assured investors that it was strong enough to absorb its Baltic losses, quashing fears it would have to raise fresh capital. The bank’s chief financial officer, said the bank had “a very resilient capital situation”

Another Swedish bank – SEB, the second-biggest banking group in the Baltic region after Swedbank, is to report activity results next week. Analysts forecast that its operating profits will be down more than 40 %.