A proposal to aid emerging-market stability

Ousmene Mandeng, the head of public sector investment advisory at Ashmore, an asset management firm, believes there is a more efficient way for emerging market central banks to use their reserves to stave off a disorderly unwinding of their capital exposures. It should, he argues, be a concrete measure as part of a global coordinated policy response to the current crisis.
Ousmene Mandeng, the head of public sector investment advisory at Ashmore, an asset management firm, believes there is a more efficient way for emerging market central banks to use their reserves to stave off a disorderly unwinding of their capital exposures. It should, he argues, be a concrete measure as part of a global coordinated policy response to the current crisis.

Many emerging markets are at risk. High capital requirements and G10 bank support schemes biased towards domestic lending are undermining emerging market borrowing. Lack of external credit has severely impaired trade and commercial activities, impacting confidence about a sovereign's credit worthiness. In turn, this has, at least in part, sparked significant depreciations of key emerging-market currencies.

Disruption to emerging markets economies will reduce prospects for a sustained recovery of the global economy.

The size of the problem is significant. Claims to emerging markets on a consolidated basis represent about 12% of total global claims. They have increased significantly from $900 billion in 2004 to $2.7 trillion in September 2008, of which $1.3 trillion are of a maturity of less than or up to one year.

To deal with this problem, at the moment many emerging market central banks are offering credit lines in foreign exchange to banks and corporates. This will work if central banks have enough reserves to cover short-term external debt. But it is an ineffective use of reserves. Also, many central banks do not have a reserves stockpile sufficient enough to cover short-term external debt, a fact which raises the grim possibility of default.

But there is an alternative: Insurance of Credit Lines for Emerging Markets (ICLEM).

The scheme uses emerging markets' reserves to back loans extended to their domestic banks and corporates by G10 banks coming due within one year. In doing so, ICLEM allows for a significantly more efficient use of international reserves than conventional credit-line substitutions and exchange-market interventions.

For example, say a G10 bank has an exposure of $100m to a large domestic company. The central bank could deposit hard currency with the bank to cover between 30% and 50% of the loan amount depending on the riskiness of the loan, which would be held in escrow on behalf of the lending institution. The provisions for capital requirements under credit risk mitigation allow banks taking eligible financial collateral to offset their credit exposures fully in the amount of the collateral. The guaranteed company may then deposit the amount of the loan in local currency at the central bank as a pledge.

This means that rather than providing the G10 bank with a credit line of $100m, the central bank would only have to provide $30m to $50m to achieve the same result. The G10 bank could meet its high capital requirement without having to withdraw funds from the emerging market and so the central bank would have no need to worry about capital flight.

The same principle applies for the capital injections, which would be used to buy the G10 banks' subordinated debt to compensate capital requirements for loans to domestic entities with additional capital injections of Tier II capital. The guaranteed company would again deposit the amount of the loan in local currency at the central bank as a pledge.

The allocation of the central bank's funds would happen by auction with the G10 banks bidding by amount and interest rate paid on deposits and/or subordinated debt. The scheme could ideally be implemented in a coordinated way but its strength lies in that it rests on a bilateral agreement between the central bank and the commercial bank.

Let's be clear. We are not suggesting this as a long-term solution. We accept that deleveraging on an important scale needs to take place. It is very much an interim measure, designed to stave off defaults and ensure an orderly unwinding. It is thus exactly the sort of concrete proposal to help foster stability now and growth in the medium term that should form part of a global response to the crisis.

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