Editor’s Note: This report was written by members of the Committee on International Economic Policy and Reform, a non-partisan, independent group of experts, comprised of academics and former government and central bank officials.
During 1999-2007, the international balance sheets of emerging economies grew stronger through
a combination of current account surpluses, a shift from debt funding to equity funding, and the
stockpiling of liquid foreign reserves. This risk-mitigating strategy improved the international
financial standing of many emerging economies and helped these economies withstand the 2008-
2009 global financial crisis.
However, a combination of domestic and external factors has led to a partial reversal of this strategy,
with some emerging economies accumulating significant external debt since 2010. Previewed
by the May 2013 “taper tantrum,” there has been considerable speculation that a tightening of
dollar-funding conditions and a macroeconomic slowdown in emerging economies may result in
financial instability in some emerging economies.
The risk of a global shock to international funding conditions is extensively documented. In view
of the central role of the dollar in international funding markets, global financial conditions are
significantly influenced by the stance of U.S. monetary policy. In particular, it is now widely accepted
that the federal funds rate plays an important role in determining the availability of dollar
In related fashion, and as recent experience with international spillovers suggests, the withdrawal
of quantitative easing by the Federal Reserve could be associated with tighter funding conditions
for international borrowers globally. If this is the case, the impact could be felt most acutely in
those emerging economies with the deepest financial markets and the poorest economic fundamentals.
The effect might come both from the quantity and the price sides since there might be a
tighter supply of dollars but, at the same time, the cost of borrowing might increase in local currency
terms. In addition, in terms of valuation effects, expected dollar appreciation will increase
the value of dollar debt, as has been witnessed during the course of the past year, where the real
burden of dollar-denominated debt has increased in emerging markets.
In addition to the shift in dollar-funding conditions, macro-financial fundamentals have deteriorated
in a number of emerging economies since 2007. Current account balances have declined
and foreign debt levels have increased. Credit growth has increased and leverage for some sectors (including the corporate sector) has climbed. Simultaneously, forecasts of potential output
growth have been revised downward, and the drop in commodity prices has damaged the income
prospects of commodity exporters.
The scale, composition, and volatility of international financial flows are a clear concern for policymakers
in emerging economies. Through a variety of channels, a reversal in international financial
flows risks destabilizing their domestic financial markets and the real sectors. Countries
running high current account deficits are particularly vulnerable to such reversals, facing the risk
of a traditional sudden stop. But those with large outstanding stocks of debt liabilities in foreign
currency could be vulnerable as well, facing both rollover risk and risks to their financial terms of
Looking at international balance sheets, the traditional focus has been on the cross-border positions
of banks and sovereigns. While these can be (and have been) sources of shocks, they are also
amplification mechanisms for the difficulties emanating in the real sector. As we have seen on a
number of occasions, a systemic financial disruption can have its origin in the strains on balance
sheets in the nonfinancial and household sectors.
The (direct and indirect) international financial positions of nonfinancial firms have been drawing
increasing attention. Large corporates can directly obtain funding from international banks,
the international bond market, and non-bank intermediaries, while small firms borrow from their
own banks in foreign currency terms. Indirectly, the corporate sector may induce financial inflows
by borrowing from the domestic financial sector that, in turn, obtains external funding. The foreign
currency debt obligations of the corporate sector are of particular concern, whether owed to
foreign creditors or domestic lenders.
Todd Stern speaks at The Economist’s Climate Risks Summit.