Risk & Compliance

The Most Serious Emerging-Market Risk

Currency volatility is an annoyance, but it's when governments institute capital controls that multinationals really have a problem.
Vincent RyanMarch 16, 2016
The Most Serious Emerging-Market Risk

In Azerbaijan, part of the former Soviet Republic, the plunge in oil and gas prices has the government raiding its sovereign wealth fund to make up a budget deficit. The nation’s currency, the manat, is worth about 61 cents (U.S.) down from $1.27 just one year ago. To stanch the bleeding, Azerbaijan has imposed a 20% tax on any transaction that takes money out of the country.

If there is anything that’s worse for multinationals than having to write down foreign assets or take a 3% hit to earnings because of unfavorable exchange rates, it’s capital controls — government measures to restrict the movement of money.

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The depression in commodity prices has heightened the risk of capital controls for multinationals doing business in emerging markets. Such restrictions affect international suppliers and lenders in many ways. Delays or even defaults in customer payments can result. A U.S. parent company can be prevented from extracting a dividend from its emerging market investment or pay a hefty toll to do so. A division of a U.S. company can find it near impossible to convert a local currency to U.S. dollars.

capital controls

Capital controls come in many forms, including taxing foreign exchange transactions, freezing outflows of hard currency, and restricting certain kinds of capital markets speculation. For example, during the eurozone crisis, Greece closed its banks and halted transfers abroad as local depositors lined up to withdraw their money. Ukraine curbed purchases of foreign currencies in 2014 as its conflict with Russia flared up. Iceland imposed capital controls during the financial crisis and only recently hinted at lifting them. Earlier in the decade, Brazil imposed a 6% tax on foreign currency when it was converted into equities or short-term debt.

The current situation arises from the sustained downturn in oil and other commodity prices globally. As David Anderson, director of global business development at Zurich Credit & Political Risk, explained to CFO, “[Many] emerging markets depend on commodity prices being high, because they tend to be commodity exporters. When commodity prices dip and stay low for a prolonged period that puts pressure on their [foreign exchange] reserves.”

FX reserves are important for many reasons: they allow a government to intervene in FX markets during currency fluctuations, to maintain the value of its current accounts, and to absorb external economic shocks.

In the situation that commodity exporting countries find themselves in now, they have three choices, says Anderson:

1). Devalue the currency. A lot of countries have already done this. Devaluation tends to reduce imports and increase exports, all things being equal. But in a slow-growing global economy, devaluation may also be insufficient to incite economic growth.

2). Raise interest rates. This will make a country’s assets more attractive when compared with countries that have lower interest rates, all things being equal. But increasing interest rates has a direct impact on a local economy — it tends to slow it down. That makes raising interest rates anathema to policymakers, especially amid current global market turmoil.

3) Capital controls. This is the tactic many governments have decided is the least painful. Capital controls prevent people and companies from moving money offshore or make it more expensive to do so.

Saudi Arabia and Nigeria, besides Azerbaijan, are two notable examples where the nation has imposed capital controls, Anderson says. Saudi Arabia has disallowed traders from shorting its currency. Nigeria has established a series of measures to stop the plunge in value of its currency, the naira. The country halted the importing of certain goods, like food and furniture. In addition, Nigeria banned the use of credit and debit cards by its citizens traveling or otherwise purchasing goods abroad. Anderson says Zurich is already starting to see potential claims in Nigeria related to problems with currency convertibility.

In general, multinational suppliers to buyers in emerging markets may see defaults by their customers or delays in payments. (These can also include receivables due from governments and state-owned enterprises.) Banks that have lent money to debtors in emerging markets may see increased probability of nonperforming loans or increased need for rescheduling a loan’s payments, Anderson says.

The economic stress on commodity export-dependent companies can also develop into political stress, says Anderson. With some of these countries suffering credit rating downgrades, they may have reduced capacity to spend on social programs that their citizens care deeply about, says Anderson. “It is not far-fetched to think there will be political ramifications if commodities prices stay at low levels in emerging markets, increasing risk of civil strife, political violence, and possible regime changes,” he says.

The risk of capital controls and resulting political risks in part depend on how long commodity prices stay where they are, says Anderson. Despite a modest rebound in the price of oil lately to the high $30 range, few experts see crude prices roaring back. The International Energy Agency predicts oil will recover to $80 by 2020, but a low-price scenario projects the price per barrel could hover in the $50 to $60 per barrel range well into the 2020s.

“We’ve been in prolonged commodity price dips before and there were major political events that came out of them,” Anderson warns.

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