Russia is not Egypt (yet)

It took a while, but capital flows to the emerging markets have turned negative. On balance more capital is now flowing out than in. The figure was still just positive in the third quarter, but a downward trend has been evident in the past months. The crisis in the eurozone, the growing pressure on banks in both Europe and the United States, and the modest global growth outlook have caused a repatriation of European and US capital.

Over the past decade the emerging world received around EUR 2 trillion. This high figure was due to strong investment flows from the United States and Europe, but also to low capital flight by businesses and households from the emerging markets themselves. What we are now seeing is above all a diminution in the first flows, as a direct consequence of the credit crisis in the developed markets. But we also see some instances of traditional capital flight, something with which so many emerging markets struggled in the final decades of the 20th century.

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Egypt offers the best example. Because of the popular uprising which first forced the resignation of President Mubarak and is now also shaking the more broadly based regime, businesses and wealthy individuals are doing all they can to secure their assets. This has led to a dramatic fall in the country’s foreign exchange reserves, from around EUR 50 billion in January to around EUR 20 billion at the moment. Because the authorities know that a sharp slide in the Egyptian pound’s exchange rate will lead to higher food prices (since Egypt buys most of its food on the international market), they are using the foreign exchange reserves to defend the currency. If the political unrest persists over the coming months, as is widely expected, then a steep depreciation of the pound seems likely. But the reserves are already significantly depleted. The economic crisis will then get worse.

After Egypt, Russia is the second country where capital flight has been significant this year. Now Russia has a tradition of strong capital flight. Ever since the collapse of the Soviet Union, there have been only a few quarters without a net capital outflow. But the pace of capital flight has accelerated sharply over the past five quarters. This is doubtless linked to the growing political uncertainty. The parliamentary elections this week have made clear that the Putin regime is less secure than it was. If the political unrest escalates, more capital will leave the country. It is too early to warn of a currency crisis, because the protests are only a few days old and above all because Russia has large financial buffers. But the example of Egypt is clear: if capital flight accelerates and the political situation does not improve quickly, then the pressure on the financial system will quickly intensify. Political leaders will then need to be clever to stay in power.