US Dollar Funding and Emerging Market Economy Vulnerabilities
The growth in external USD financing from non-bank financial institutions following the 2008 global financial crisis has created new financial stability challenges for emerging market economies.
For most of the decade prior to the COVID-19 pandemic, abundant global liquidity – combined with low interest rates in advanced economies (AEs) and a search for yield among investors to boost their returns – helped to support the capital flows to EMEs. These inflows provided EMEs with the benefits of greater access to international capital markets but also contributed to the build-up of vulnerabilities. Non-bank financial institutions (NBFIs) also played an increasing role in funding EME external debt. While this development added to the diversity of EME funding sources, it created new challenges for EMEs.
The COVID-19 outbreak led to large declines in EM asset prices during March 2020, which, in some cases, were comparable to those witnessed during the GFC. Sales by foreign investors resulted in large-scale capital outflows in some jurisdictions and contributed to local currency depreciation. During this episode, EM investment funds experienced substantial redemptions that were larger than the 2013 ‘taper tantrum’. Analysis suggests that jurisdictions which relied more on global and passive bond funds tended to face greater capital outflows. Sovereign rating downgrades may have added to corporate borrowing costs at least in some jurisdictions.
EME authorities deployed both standard crisis management tools and new measures, such as large-scale asset purchases, to mitigate pressures in local currency bond markets and to stem capital outflows during March 2020. Actions by AE authorities were also important in mitigating strains in financial markets globally and addressing USD funding pressures. However, the report notes that these actions did not directly address the underlying vulnerabilities in EMEs.
The report proposes a number of policy measures that seek to reduce EME vulnerabilities stemming from external funding and non-bank financing, as well as to enhance crisis management tools. These include measures to:
- limit the build-up of non-financial corporate foreign currency mismatches;
- further develop foreign currency hedging markets at the domestic and regional levels to manage currency risks;
- deepen local currency debt markets and foster a broader domestic investor base; and
- tackle NBFIs’ vulnerabilities, including those relating to liquidity mismatches in open-ended funds.
The report also encourages authorities to give further consideration to closing data gaps to facilitate risk monitoring and the timely adoption of policies to mitigate external EME vulnerabilities.