>EMERGING MARKETS MACRO AND STRATEGY OUTLOOK (CITI)

Out of the frying pan? Fiscal vulnerability takes centre stage

■ At the risk of great oversimplification, we think emerging economies have passed through two phases of the global crisis, and are now entering a third.

■ The first phase could be labelled the Financial Vulnerability Phase. At the centre of this was the loan-to-deposit ratio. Countries with a high loan-to-deposit ratio were vulnerable to the immediate consequences of the collapse in foreign banks’ desire for counterparty or credit risk; and their need to bring resources back to their own balance sheet.

■ An External Vulnerability Phase may have succeeded this, in which the central concern was with countries who, regardless of the health of their banking systems, became vulnerable because of the large size of their external financing needs. The External Vulnerability Phase coincided in some cases with the Financial Vulnerability Phase.

■ The External Vulnerability Phase seems to be at an end, thanks to i) sharp improvements in trade balances in many countries; ii) the IMF’s commitment to inject larger amounts of liquidity into emerging economies on easier terms; and iii) the re-emergence of risk appetite, particularly among bond and equity investors.

■ The import compression that has helped to improve the trade balance in many countries has a flipside in very weak growth. That in turn helps to give rise to the third phase of the crisis, a Fiscal Vulnerability Phase, as budgets come under pressure. Thanks to budget discipline in many countries during the past few years, we believe the Fiscal Vulnerability Phase poses fewer risks than what has passed before. The countries most at risk here are likely to be ones with unrealistic budget assumptions and high debt/GDP ratios.

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