Swimmers at high-tide. (Shutterstock)
Swimmers at high-tide. (Shutterstock)

An earlier post, here, pointed out that strengthened policy frameworks in many emerging market economies have reduced the risks of contagion. As a result, notwithstanding concerns about emerging market vulnerabilities in the wake of Fed tapering of quantitative easing, financial markets may discriminate between countries in contrast to past episodes of monetary policy "rebalancing."

The change in policy frameworks has been impressive. Many countries have adopted inflation-targeting regimes, eschewing commitments to fixed or targeted exchange rates. Important progress has been made towards controlling off-balance sheet liabilities and the debt issuance of sub-national jurisdictions. And many governments have improved public debt management, lengthening the term structure of outstanding debt and reducing currency mis-matches by issuing domestic currency debt.

These measures should mitigate risks from a sudden stop of capital flows. That being said, a recent report from the Inter-American Development Bank, here, highlights a potential complication. The report points out that some of the risk mitigation benefits of reduced sovereign borrowing mis-matching could be offset by a large increase in private sector borrowing in foreign currency.

Firms in the region and their subsidiaries, seeking historically low interest rates, have issued a large amount of foreign currency denominated debt. These firms could be exposed to exchange rate adjustments if large gaps open up between their dollar-denominated liabilities and domestic currency revenue streams. Moreover, there is a risk that private debt difficulties could become public sector challenges as currencies come under stress and firms face bankruptcy.

Such concerns are amplified in the current environment, particularly the effects of capital flow reversals since the "taper tantrums" induced by the Fed's slowing of QE purchases. The change has been significant; given that the current account is the inverse of the capital account for unchanged foreign exchange reserves, this implies substantial impacts in terms of current account adjustment, real exchange depreciation and growth. At the same time, while reserve accumulation has increased, the pace of accumulation has not matched the evolution in desired or optimal reserves. In such conditions, a number of LAC swimmers may be revealed to not have a bath suiting as the tide of capital flows recedes.

All of this underscores the key message for governments in the region: move forward with a range of structural reforms to raise potential growth and better protect their economies against the shocks that might be encountered.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.