As announced by the IMF today Mexico was the first country to indicate its interest in the Flexible Credit Line, dedicated for emerging markets countries with strong fundamentals, and not subject to any policy conditionality. Mexico, if approved by the Board, will draw up to $47bn, ten times its quota at the IMF.

Mexico is an investment grade country BBB+, but it is perceived as a country where the rule of law is hardly enforced. Therefore it is worth asking whether sound economies from Central and Eastern Europe, such as Poland,  should consider tapping IMF FCL to fill the foreign funding gap. The question should go even further. Austrian banks lent to the CEE countries an equivalent of 70% of Austria GDP, so problems with the region will inevitably lead to a collapse of Austria financial sector. Poland or Czech Republic would feel highly uncomfortable to be in the same basket as Mexico, but I would make a hell lot of a difference if Austria used FCL, as a precautionary instrument, and then recapitalized its daughter banks in CEE, which would help avoid recession in the regiona and will help Austrian banks (which will be burnt in Ukraine anyway). After Austria, Czech Republic and Poland could participate as well, and the threat of a crisis looming over this part of the world would definitely be over. For your information FCL accesibility conditions are below:

“The pre-set qualification criteria are at the core of the FCL and serve to signal the Fund’s confidence in the qualifying member’s policies and ability to take corrective measures when needed. At the heart of the qualification process is an assessment that the member (a) has very strong economic fundamentals and institutional policy frameworks; (b) is implementing-and has a sustained track record of implementing-very strong policies, and (c) remains committed to maintaining such policies in the future. The relevant criteria for the purposes of assessing qualification for an FCL arrangement include: (i) a sustainable external position; (ii) a capital account position dominated by private flows; (iii) a track record of steady sovereign access to international capital markets at favorable terms; (iv) a reserve position that is relatively comfortable when the FCL is requested on a precautionary basis; (v) sound public finances, including a sustainable public debt position; (vi) low and stable inflation, in the context of a sound monetary and exchange rate policy framework; (vii) the absence of bank solvency problems that pose an immediate threat of a systemic banking crisis; (viii) effective financial sector supervision; and (ix) data transparency and integrity. Strong performance against all these criteria would not be necessary to secure qualification under the FCL, as compensating factors, including corrective policy measures under way, would be taken into account in the qualification process”.

Carmen Reinhart and Kenneth Rogoff wrote a paper which draws parallels between recent US subprime market and banking crises in history. It is short and very illustrative. A quote:

“Another parallel deserves mention. During the 1970s, the U.S. banking system stood as an intermediary between oil-exporter surpluses and emerging market borrowers in Latin America and elsewhere. While much praised at the time, 1970s petro-dollar recycling ultimately led to the 1980s debt crisis, which in turn placed enormous strain on money center banks. It is true that this time, a large volume of petro-dollars are again
flowing into the United States, but many emerging markets have been running current account surpluses, lending rather than borrowing. Instead, a large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders. Over a trillion dollars was channeled into the sub-prime mortgage market, which is comprised of the poorest and least credit worth borrowers within the United States. The final claimant is different, but in many ways, the mechanism is the same.”

US exorbitant privilege (ability to pay very little for foreign liabilities and make high returns on foreign assets) is going away faster that I thought. After capital injections by Abu Dabi into Citi, it was announced that China Investment Corporation buy 9.9% (USD 5bn) stake in Morgan Stanley. CIC is said to remain a passive investor without any special right to name board members.

Think what it means for a moment. In the last few decades US borrowed cheaply from world central banks and private investors at its treasury yield and invested in private and public equities worldwide. With subprime crisis hitting asset values in the US, emerging markets wealthy investors (including SWFs) step in and buy cheaply, which indicates that once situation stabilizes (and it always does, question is when) these investors will be able to enjoy very high returns (as a premium for courage to buy in bad times).

It could still work out in the US favor. It may be that over the next decade returns in emerging markets will be high relative to US markets and EM currencies will appreciate against the dollar, so US makes more on foreign assets than it pays for its foreign liabilities. But this scenario is expected by many investors, so the home bias should fall anyway and Asian and Gulf investors will also buy more EM assets, relative to historical averages. Taking all this into account I draw a conclusion that US will no longer be able to play the global hedge fund role (taking leverage and buying equity, to put it simple). Transactions such as Blackstone, Citi, Morgan Stanley, and maybe more to come do suggest that world has changed, and that many capital surplus nations are accepting higher credit risk in exchange for higher expected return in the longer run.

This must lead to fast changes in the global financial architecture. I expect China financial markets to dwarf those in UK and US, and I expect that it will happen sooner than most people predict. To get a feel for a pace of change recall that China share in global exports of telecom equipment went from 7% to above 20% in just five years, machinery exports from 3 to 9% in five years. So fasten your seat belts, the ride begins …

Later addendum: Merill Lynch has just announced that Singapore based Sovereign Wealth Fund Temasek may buy a 5bn stake in the bank, and that this investment may not be a passive one.