2018 - 2019 Edition of Citi Perspectives for the Public Sector

Citi Perspectives for the Public Sector |  2018-2019 31 A divergent impact on EMs The above factors present a worrying situation for many EM countries. Stresses on the world’s physical and governance infrastructure intensify the need for EMs to maintain fiscal flexibility in the face of these growing pressures. In difficult conditions, many EM economies would be unable to marshal sufficient financial resources to respond effectively in the event of an external shock, thereby leading to a crisis. However, the above trends will have dissimilar impacts on different EMs. Whether because of resource endowments or economic structural advantages, some countries are better insulated than others from the challenges of the new environment. The Sovereign Advisory team uses the following attributes as key indicators of an economy’s vulnerability: • Simultaneous and chronic fiscal and current account deficits. Countries with twin deficits typically rely on local and/or foreign currency debt to meet their financing needs. Some strong economies that offer attractive growth opportunities run twin deficits, but these countries can more readily depend on positive investor sentiment to do so. As a result, they can more often draw on equity sources of financing, such as foreign direct investment, rather than debt. However, a loss of confidence or market shock could cause a sudden stop or even reversal of both equity and credit inflows. For externally indebted countries, a sharp rise in foreign currency (external) borrowing rates could prevent local borrowers, including the government, from rolling over debts or obtaining fresh financing, precipitating defaults or a budget crisis. Local currency lenders can replace external investors only if domestic markets have sufficient depth to provide liquidity in the volumes required. This is not often the case in EMs. As such, EMs with twin deficits are particularly vulnerable to global debt trends and external shocks. • High level of government debt as a percentage of budget revenues, especially when a high proportion of that debt consists of currently due and/or short-term external obligations. Governments with large debts must dedicate a correspondingly large portion of their revenues to debt service. This constrains their discretionary spending, which can have a negative knock-on effect on growth and, in turn, on future revenues. In such cases, the government’s cost of borrowing is usually higher than that of less- indebted peers, increasing the likelihood of default. When a large portion of the debt is denominated in foreign currency and made up of short-term maturities, the government’s flexibility is further limited. • High levels of external debt in relation to foreign currency revenues (measured by current account receipts), especially when foreign exchange reserves are low. This measure captures a country’s ability to make its international payments. Current account receipts are foreign currency inflows and constitute the most ready source of funds to meet outbound obligations. When outbound fund flows greatly exceed inbound flows, the country might be compelled to dip into its foreign exchange reserves to make the payments. If reserves are thin, the country can buy foreign currency — but this can trigger currency depreciation and also lead to default. • High dependence on commodities as a percentage of total exports. It is comfortable to be a commodity exporter when global prices are high and stable, and much less so when they are low. Price volatility is itself difficult for commodity exporting countries to manage. It introduces uncertainty into government budgets and increases the likelihood that governments will at times overestimate future revenues, potentially causing them to boost spending to an unsustainable level. The greater a country’s dependence on commodity exports, the greater the expected cost of such a mistake. Stresses on the world’s physical and governance infrastructure intensify the need for EMs to maintain fiscal flexibility in the face of these growing pressures.