Cross-border Capital Flows Volatility: Challenges for Ukraine, – Tetiana Bogdan’s blog

Following the acute phase of turbulence in March-May 2020, foreign capital began to return to emerging market economies. After all, the level of interest rates in mature markets has declined markedly since the beginning of monetary stimulus in advanced countries (the growth of assets of the world’s leading central banks – the ECB, US Federal Reserve and Bank of Japan – for the year was 52%). But the massive inflows of capital into emerging market economies is opportunistic, and after some time we are likely to see a slowdown or even reversal of capital flows due to fundamental economic factors.

Since February 2020, emerging market economies have been heavily affected by the pandemic and have suffered from the many destructive effects of quarantine restrictions, weak global demand and declining labor mobility. And in the next decade, these countries will also face acute challenges in attracting external loans and investments. Moreover, in countries with high current account deficits, it may prove impossible to replace the lost capital inflow with domestic savings. This will undermine the economic prospects of many developing countries, causing economic stagnation and the spread of poverty.

According to international experts, in the long run, the decline in domestic investment due to the pandemic and economic crisis, exacerbated by reduced foreign capital inflows, will reduce potential output in emerging market economies (Barclays. Equity Gilt Study 2020: Putting the post-COVID world in context). And this situation will be fundamentally different from the effects of financial globalization, when large-scale foreign capital inflows into emerging market economies boosted gross fixed capital formation in these countries, acting as a factor of economic growth until 2020. In the post-pandemic era, slower labor productivity growth will make emerging market economies less attractive to long-term capital flows, including foreign direct investment (FDI).

Even in the period before the COVID-19 pandemic, growth in populism, protectionism and non-tariff trade barriers in the global scale were drivers of declining FDI flows, which affected developing countries the hardest. Under the same factors, global value chains, which had traditionally mediated the inflow of long-term foreign capital to developing countries, collapsed. Similarly, technological shifts caused massive automation of production and marketing, which pushed for the restructuring of global value chains and their return to countries of origin (re-shоring).

Thus, in the post-COVID world, many emerging market economies will face challenges of reducing long-term foreign capital inflow into national economies. According to IMF experts, some countries in this group are already facing problems related to refinancing existing debts and need significant inflows of new financing. This situation can drive debt stress and cause macro-financial instability in these countries (Global Financial Stability Report, October 2020).

According to J. Bulow, C. Reinhart, K. Rogoff, C. Trebash, there are still reasons for concern about stable access of emerging market economies to international capital markets. In addition to reducing FDI flows, remittances from the migrants to developing countries continue decreasing. At the same time, financing needs in these countries have skyrocketed, emerging market and developing economies contend with the same economic and humanitarian stresses as advanced economies. Borrowing and investment needs of poor countries will only rise further as the economic damage mounts. And with high synchronized external financing needs, debt will have to be restructured for a large number of countries. Threats of debt restructuring, in turn, will be accompanied by a wave of credit rating downgrades for borrowers from emerging markets.

The outlined negative processes associated with the COVID-19 pandemic are likely to increase risk premiums for all types of assets in these markets in the medium term. The strength of this impact will vary from country to country and asset class, but countries with the high degree of external openness, unfavorable investment climate and low credit ratings will suffer the most. All of these characteristics are typical of the economy of Ukraine, and therefore there are more than enough reasons for pessimistic assessments.

If we consider the socio-political determinants of increasing spread for emerging market economies, then under the influence of the long-term negative effects of the pandemic, popular discontent and protests may resume with renewed force after the end of the pandemic. Even now the pandemic inflicts heavy losses on the most vulnerable segments of the population (the poor and those who have fewer opportunities to work from home and who worked in the hotel business, tourism, trade before the crisis). If reduced remittances from relatives abroad and the limited ability of low-income governments to implement job-saving or wage-replacement programs are added to this, social inequality growth becomes apparent, both during and after the pandemic. This situation will increase public discontent and fuel social protests.

Socio-political processes will also affect the intensity of the foreign capital inflow into emerging market economies. An empirical study of the determinants of emerging market sovereign bond spreads showed that the spreads of countries where social protests took place were much worse than those of socially stable countries (Barclays. Equity Gilt Study 2020).

Thus, in the medium and long term, the main determinants of  reducing the inflow of long-term foreign capital into emerging markets, as well as raising interest rates for borrowers will be: reduction of international trade and cross-border labor mobility, growth of trade protectionism, precautionary investor demand for risky assets, slowdown in labor productivity and domestic investment in these countries, increase in public debt and budget deficits, rising projected inflation, selective implementation of capital controls, domestic socio-political instability of these countries.

In the post-pandemic era, new global threats and challenges will  significantly increase the risks of currency and debt crises in countries with high debt burdens and significant needs for external financing. In this context, the fact of a high Ukraine’s external debt burden is quite alarming. 

Comparison of external debt indicators of low- and

middle income countries and Ukraine as a %

Source: World Bank International Debt Statistics 2021, author’s calculations

According to the latest data from the World Bank, at the end of 2018 the ratio of external debt to exports of goods and services in Ukraine (160.7%) was 1.6 times higher than the average level of low- and middle-income countries (101%). And the ratio of external debt to gross national income (90%) in Ukraine was almost 3.5 times higher than the average level (see table). In 2020, the ratio of external debt to exports in Ukraine further worsened (to 212.5%), and the ratio to gross national income slightly improved (to 84.8%).

 The high level of Ukraine’s gross external debt rise the vulnerability of individual borrowers’ to changes in global financial market conditions: changes in liquidity / monetary policy of leading central banks, the risk appetite of international investors, etc. In addition, in the post-pandemic era, Ukraine, like many emerging market economies, will objectively face the problem of reducing the long-term private capital inflow into the national economy and increasing its value. Higher risk premiums in the yield of Ukrainian instruments will be associated with the following factors: a) higher projected inflation in Ukraine, b) significant fiscal risks and high levels of gross external debt, c) increased risks of external vulnerability of Ukraine’s economy, d) the possibility of mass social protests and their negative impact and the state of debt sustainability.

This means that the problems of the external financing deficit for Ukraine will become chronic, and the risks of Ukraine’s balance of payments instability will go up. Therefore, in the coming years, Ukraine will urgently need a reorientation of financial and investment policies towards intensifying the domestic sources of investment financing and covering the financing requirements. The fact that the devaluation of dollar savings of households and businesses in 2020-2021 will encourage them to seek the alternative ways of investing also points in favor of such reorientation. In this context, Ukraine’s broad and diversified domestic capital market, as well as a healthy bank loan market for Ukraine’s business sector, should become worthy alternatives to volatile foreign capital.

Doctor of Economics, Scientific Director at Growford Institute Tetiana Bogdan for LB.UA