FALLOUT FROM TIGHT GLOBAL FINANCING
Tighter global financing conditions raise debt affordability and government liquidity risks, particularly for some frontier markets. Global financing conditions will tighten further, as withdrawal of monetary policy accommodation continues in the US and commences in the euro area. Frontier markets in APAC are particularly vulnerable to any resulting decline in capital inflows or outright outflows, weakening of local currencies, and/or increase in borrowing costs. Debt affordability will weaken as external funding costs mount, and the value of foreign debt will increase, inflated by depreciating local currencies. Pronounced currency weakening would also raise inflation and prompt domestic rate hikes, which would push up local currency borrowing costs and further weaken governments' fiscal positions.
As a region, APAC will be relatively resilient. Generally large external buffers and a gradual reduction in reliance on external financing, driven by the increase in domestic savings and deepening of domestic markets, will support emerging and frontier markets in APAC in general, compared with other regions and relative to 2008, ahead of the global financial crisis. Government external debt to GDP has declined in APAC and, on average, is the lowest among emerging and frontier economies globally, while external buffers – measured by foreign reserves coverage of total goods and services imports – have increased and are higher than in other regions. There is also a general absence of macroeconomic imbalances for most countries in the region, with a few exceptions.
Economies with sizeable twin current account and fiscal deficits and/or with a significant reliance on external financing are especially vulnerable to the shift in global funding conditions. The risk is particularly elevated for those with current account deficits that are not fully financed by stable, long-term capital inflows, that have large gross borrowing requirements, and/or that borrow heavily from external sources on commercial terms. Maldives' current account deficit is particularly wide, and not fully funded
by stable foreign direct investment (FDI), raising the country's susceptibility to capital flow volatility.
Current account deficit is likely to widen to 16 per cent in 2019, only half of which will be funded by FDI inflows. This puts pressure on foreign reserves given the country's fixed exchange rate regime. That said, the share of foreign currency debt is not particularly high and is largely owed to multilateral or bilateral lenders on concessional terms. Current account deficits are also very wide in Cambodia and Mongolia, at around 8-9 per cent of GDP, but fully funded by FDI inflows.
Foreign exchange reserves are low, and gross borrowing requirements are large in Pakistan and Sri Lanka, threatening the ability of these governments to refinance debt and fund deficits affordably. Foreign exchange reserves have declined owing to persistent current account deficits, which have widened over the past two years. Moody’s external vulnerability indicator (EVI)5 reading for both countries exceeds 160 per cent for 2019, indicating that total public and private external debt due over the next year is larger than foreign exchange reserves. The reserves coverage of imports has also fallen, particularly in Pakistan, where reserves are now worth less than two months of goods and services imports.
Tighter global funding conditions resulting in higher credit risk premia and/or domestic interest rates would quickly transmit to government finances in both countries – where debt affordability is already weak – owing to large gross borrowing requirements. For Sri Lanka, further political tension could also spark capital outflows and raise the country's risk premia, exacerbating tight financing conditions.
Stable sources of external funding, large domestic savings lower external vulnerability in other APAC economies with twin deficits. Among the other emerging and frontier market economies, limited dependence on short-term capital flows to fund current account deficits, low commercial foreign currency debt, and/or large pools of domestic savings that governments can rely upon to fund deficits provide resilience to global financing shocks. In India and Fiji, large domestic savings in banks and the national provident fund, respectively, coupled with ample foreign exchange reserves limit external vulnerability risks. External debt in India is also very low.