Economic Research Forum (ERF)

Recent financial and debt crises: is the MENA region immune?

How vulnerable is the MENA region to a ‘sudden stop’ in capital inflows and the potential for associated financial and debt crises? This column outlines the risks and the appropriate policy responses.

In a nutshell

In 2019, all MENA countries are likely to suffer the impact of slower global growth, lower receipts from oil-producing countries, and further increases in budget deficits and government debt due to higher spending and dwindling tax revenues.

Failure to tackle deteriorating macroeconomic fundamentals could lead to an exchange rate or debt crisis.

To avoid a potential sudden stop in capital inflows, MENA policy-makers will need to introduce macroeconomic policy measures that could trigger rapid and large adjustment in the individual country’s current account.

The last three decades have seen financial, debt and exchange rate crises in many emerging economies, including the Chilean debt crisis of 1982 and the Mexican crisis of 1994 (see Neaime, 2012, 2015a, 2015b, 2016).

In Chile, the ‘sudden stop’ in capital flows translated into a sharp reduction in GDP growth rates. In Mexico, the crisis was triggered by a devaluation of the peso to correct for a real exchange rate overvaluation that was causing a fall in economic growth. But the devaluation led to a contraction in the economy, and was then followed by a debt crisis.

More recent examples include the Asian crisis of 1997, which was triggered by a combination of poor financial governance, the maintenance of pegged exchange rate regimes, fast capital account liberalisation and weaknesses in the Asian financial systems.

The 1998 Russian crisis was triggered by the steep devaluation of the rouble by about 250%, which led to a significant growth of Russia’s external debt and its debt service, the collapse of the Treasury Bills market and a commercial banking crisis, a worsening of the budget deficit caused by reduction of the tax base, coupled with the impossibility of further debt financing of the budget deficit.

There was also the 1999 Brazilian crisis and the 2001 Argentine debt crisis. These were the result of many years of deficit financing through printing money in Brazil and Argentina, leading to hyperinflation and the subsequent default of Argentina on its external debt. Turkey in 2001 also experienced hyperinflation as a result of deficit financing, but managed not to default on its external debt obligations.

More recently, we have had the 2008 US financial crisis; the 2012 Greek debt crisis, triggered by past accumulated public debt and deficits; and the Turkish currency crisis of 2018, in which the lira depreciated by about 200%.

It is clear that the MENA region shares some of the macroeconomic characteristics of these other countries that have led to crises, making the region vulnerable to potential financial or debt crises.

According to Mendoza (2010), after a sudden stop in capital inflows, interest rate spreads in emerging economies will tend to skyrocket. This situation is then exacerbated by currency devaluation (another consequence of the sudden stop) in the presence of a high level of public and private debt in foreign currency. To that end, a real devaluation implies a sharp rise in external financing costs and a revaluation in the stock of debt, which might induce a much larger adjustment in debt stocks and may set in motion a credit crunch.

Moreover, when a systemic collapse in capital flows occurs (sudden stop), domestic financial vulnerabilities act as amplifiers of the external shock; this may subsequently lead to a financial/debt crisis.

After the sudden stop in capital flows and a sharp reduction in GDP growth rates in Chile, painful macroeconomic adjustments measures were introduced despite solid initial macroeconomic fundamentals. The sudden stop in Chile was estimated at 7.9% of GDP, the largest among Latin American countries (Reinhart and Calvo, 2000).

In Argentina, a sudden stop was transformed into a full-blown financial crisis and economic collapse, which could have perhaps been averted by the prior introduction of painful macroeconomic adjustment measures.

We know that sudden stops in the inflows of capital are mainly triggered by weak developments in the domestic financial markets. It is also well known that countries that receive short-term capital flows in the form of portfolio flows and bank deposits and loans are more prone to capital reversal and sudden stops.

Borrowing from international financial markets can smooth an adverse shock to current income, such as deterioration in the terms of trade and a subsequent deterioration in the current account associated with a decrease in the inflow of foreign capital.

The European Union’s (EU) debt crisis and the 2008 US financial crisis have developed into the most severe worldwide economic crisis since the Great Depression. What has prevented an even more important upshot was the introduction of a spectacular fiscal and monetary stimulus package in the United States and EU countries.

But the price docket for these crises remains a record-breaking high. In addition to its severe effects in North America and the EU, the 2008 US crisis has put pressure on emerging economies worldwide, contributing to fast declines in their stock markets, GDP growth rates, oil prices and revenues, commodities exports, foreign direct investment (FDI), portfolio inflows, tourism revenues, and workers’ remittances.

While the United States, some EU countries, and a number of large emerging market countries are now exhibiting some signs of recovery, the effect of both the US and EU crises on the MENA countries of Algeria, Egypt, Jordan, Lebanon, Morocco, Syria and Tunisia, already burdened by the military, political, and social conflicts under the Arab Spring, has not yet fully unfolded. It is possible that the negative economic and social consequences of the crises will be felt for some time to come.

While weaknesses in the financial sectors of some MENA countries made the transmission of the financial crisis into the region a source of concern, sudden stops in capital flows have so far been averted (Michelis and Neaime, 2004).

Moreover, lower growth prospects in the more advanced economies, higher public debt service costs and a decrease in remittances are leading to soaring current account and budget deficits, and are a source of concern for the sustainability of the current fixed exchange rate regimes in several MENA countries and may translate into sudden stops if these negative macroeconomic fundamentals persist in the near future (see Neaime, 2000; 2005; Mansoorian and Neaime, 2003; and Mora et el, 2013).

On the other hand, some MENA countries still suffer from the absence of bond markets, a combination of inadequate financial sector supervision, poor assessment and management of financial risk, and the maintenance of fixed exchange rates. These factors among others have accentuated the effects of the US and EU crises in the region.

Although trade and globalisation issues and the financial integration of the MENA countries’ financial systems with the more mature financial markets of the EU and the United States were among the main reasons why the crises affected the region, it was accentuated by domestic macroeconomic, fiscal, monetary and financial issues, notably the existence of fixed exchange rates, underdeveloped domestic stock and bond markets, high real interest rates and limited fiscal space in some of those countries (see Neaime, 2004a, 2004b, 2008, 2010).

MENA countries have been moderately hit by the recent financial and debt crises. A low degree of integration with international capital markets was instrumental in preventing a severe financial crisis (Gaysset et al, 2019; Neaime and Gaysset, 2017, 2018; and Neaime et al, 2018). Limited exposure of the banking system to derivative products, and positive spillovers from increased public spending in the countries of the Gulf Cooperation Council (GCC) have helped MENA countries so far in avoiding a debt and exchange rate crises.

The negative spillover effects from the EU and the United States have been through a reduction in capital flows (exports, FDI, remittances and tourism revenues) but were not severe enough to constitute sudden stops. Some MENA countries, such as Algeria, Egypt, Morocco and Tunisia, have been highly exposed to the slowdown in the EU (their main partner for trade and remittances) while Jordan, Lebanon and Syria have been highly exposed to slowdowns in the GCC region, mainly through the channel of workers’ remittances.

For 2019, a slow recovery in of the world economy, combined with limited scope for further countercyclical government policy action, imply that average real GDP growth will remain relatively flat. MENA policy-makers therefore need to focus on further developing their respective financial markets and on creating more sophisticated bond markets.

Moreover, to safeguard price and financial stability and the soundness of public finances and the banking system, credible macroeconomic and financial strategies should be introduced.

Two key factors for the medium term are to focus on post-war reconstruction and recovery; and to pursue sound financial and monetary policies. MENA commercial banks are generally well capitalised, but non-performing loans remain high in some cases. In the long run, enhancing MENA countries’ bond markets should become a priority to reduce the reliance on short-term hot capital flows (which may translate into sudden stops) and to contain the exchange rate risk (Hakim et al, 2000).

In the short run, MENA countries need to strengthen the orderly workout of financial/corporate balance sheet effects of asset price falls on one hand, and promote financial markets development on the other. But in some MENA countries, such as Egypt, Jordan and Lebanon, limited fiscal space, real exchange rate appreciation and sluggish external receipts imply recovery will be a far-reaching goal and a potential crisis perhaps inevitable.

The focus of future economic policy will need to shift towards financial sector development. In the long run, the focus will need to shift toward raising MENA countries’ productive capacity. Addressing unemployment and poverty calls for greater private sector-led growth.

Potential risks for MENA countries are as follows: higher levels of accumulated public debt and budget deficits; weaker revenues from exports, tourism and remittances; fixed exchange rates; and sudden stops or reversal in capital flows especially for Egypt, Jordan and Lebanon. If these trends continue to plague those countries, then a potential exchange rate/debt crisis may become inevitable.

Moreover, the slowdown in EU countries will continue to affect North Africa, while the slowdown in GCC countries will continue to affect the whole region. In 2019, all MENA countries are likely to suffer the impact of slower growth (which will hamper ‘growing out of debt’), lower receipts from oil-producing countries, and further increases in budget deficits and government debt due to higher spending and dwindling tax revenues. Failure to tackle deteriorating macroeconomic fundamentals could lead to an exchange rate or debt crisis.

To avoid a potential sudden stop in capital inflows, MENA policy-makers will need to introduce macroeconomic policy measures that could trigger rapid and large adjustment in the individual country’s current account – for example, through a large real depreciation of the domestic currency – in order to resolve external disequilibria and accommodate a sudden stop in capital flows.

The larger the tradable sector, the less likely a sudden stop will generate a financial crisis. Policy-makers will also have to introduce appropriate changes in the real exchange rate to accommodate a sudden stop in capital flows. Finally, policy-makers will have to introduce financial policies aimed at increasing MENA countries’ savings in order to reduce debt levels (Calvo and Talvi, 2005).

Further reading

Calvo, Guillermo, and Ernesto Talvi (2005) ‘Sudden Stop, Financial Factors and Economic Collapse in Latin America: Learning from Argentina and Chile’, National Bureau of Economic Research Working Paper No. 11153.

Gaysset, Isabelle, Thomas Lagoarde-Segot and Simon Neaime (2019) ‘Twin Deficits and Fiscal Spillovers in the EMU’s Periphery: A Keynesian Perspective’, Economic Modelling 76: 101-16.

Hakim, Sam, Simon Neaime and CC Paraskevopoulos (2000) ‘Perspectives on the Integration of Financial Markets – Global Financial Instability’.

Mendoza, Enrique (2010) ‘Sudden Stops, Financial Crises, and Leverage’, American Economic Review 100(5): 1941-66.

Mansoorian, Arman, and Simon Neaime (2003) ‘Durable Goods, Habits, Time Preference, and Exchange Rates’, North American Journal of Economics and Finance 14(1): 115-30.

Michelis, Leo, and Simon Neaime (2004) ‘Income Convergence in the Asia-Pacific Region’, Journal of Economic Integration 19(3): 470-98.

Mora, Nada, Simon Neaime and Sebouh Aintablian (2013) ‘Foreign Currency Borrowing by Small Firms in Emerging Markets: When Domestic Banks Intermediate Dollars’, Journal of Banking and Finance 37(3): 1093-1107.

Neaime, Simon (2000) The Macroeconomics of Exchange Rate Policies, Tariff Protection and the Current Account: A Dynamic Framework, AFP Press.

Neaime, Simon (2004a) ‘Sustainability of Budget Deficits and Public Debt in Lebanon: A Stationarity and Cointegration Analysis’, Review of Middle East Economics and Finance 2(1): 43-61.

Neaime, Simon (2004b) ‘South-South Trade, Monetary and Financial Integration and the Euro-Mediterranean Partnership: An Empirical Investigation’, Femise Research Network.

Neaime, Simon (2005) ‘Portfolio Diversification and Financial Integration of MENA Stock Markets’, in Money and Finance in the Middle East: Missed Opportunities or Future Prospects? Vol. 6: 3-20.

Neaime, Simon (2008) ‘Twin Deficits in Lebanon: A Time Series Analysis’, Lecture and Working Paper Series No. 2, Institute of Financial Economics, American University of Beirut.

Neaime, Simon (2010) ‘Sustainability of MENA Public Debt and the Macroeconomic Implications of the US Financial Crisis’, Middle East Development Journal 2: 177-201.

Neaime, Simon, (2012) ‘The Global Financial Crisis and the Euro-Mediterranean Partnership’, Europe and the Mediterranean Economy.

Neaime, Simon (2015a) ‘Sustainability of Budget Deficits and Public Debts in Selected European Union Countries’, Journal of Economic Asymmetries 12: 1-21.

Neaime, Simon (2015b) ‘Twin Deficits and the Sustainability of Public Debt and Exchange Rate Policies in Lebanon’, Research in International Business and Finance 33: 127-43.

Neaime, Simon (2016) ‘Financial Crises and Contagion Vulnerability of MENA Stock Markets’, Emerging Markets Review 27: 14-35.

Neaime, Simon, and Isabelle Gaysset (2017) ‘Sustainability of Macroeconomic Policies in Selected MENA Countries: Post Financial and Debt Crises’, Research in International Business and Finance 40: 129-40.

Neaime Simon, and Isabelle Gaysset (2018) ‘Financial Inclusion and Stability in MENA: Evidence from Poverty and Inequality’, Finance Research Letters 24: 230-37.

Neaime, Simon, Isabelle Gaysset and Nasser Badra (2018) ‘The Eurozone Debt Crisis: A Structural VAR Approach’, Research in International Business and Finance 43: 22-33.

Reinhart, Carmen, and Guillermo Calvo (2000) ‘When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options’, IMF paper.

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