Emerging Market Toxic Assets: The IMF Questions Russia

Includes: BKF, FNI, FXI, PXH, RSX
by: William Gamble

According to the Financial Times (June 2, 2009), the IMF has questioned the extent of bad debts in Russia. They should.

IMF tells Russia to check extent of bad loans

The International Monetary Fund yesterday called on Russia's central bank to start stress testing domestic banks as loan delinquencies rise.

Russia's central bank estimates that the percentage of loan delinquencies is 3.7 per cent of total banking assets as of the end of March, but experts say this may understate the problem, as bad loans are calculated in Russia differently than in most countries.

"The CBR does not have a full picture of the situation in the banking system, and plans for how to ensure that the banks are adequately capitalised still need to be formalised," Poul Thomsen, deputy director of the IMF's European department...

Mr. Thomsen advised caution, saying no one knows the full scale of the problem. "I don't think it is possible to make a reliable forecast before one has undertaken the kind of analysis we are proposing," he said.

This is a good example of the informational risk in emerging markets. There have been some large run ups in emerging markets recently. I believe that they are the result of excess liquidity and carry trades, but ostensibly the prices are supposed to reflect the greater growth potential. The reality is that potential growth will depend on the health of the banking systems and no one knows how healthy they are, probably not even local bank regulators. Despite the publicity, bankers in every country made bad bets, not just in the US.

I am not sure when the truth about emerging market toxic assets will become clear to the market. Remember that information has value and it is only disclosed for consideration or if there is an enforced legal disincentive. In emerging markets there are very large economic incentives to suppress the information and insufficient legal disincentives to reveal it. The stress tests in the US were criticized as inadequate and perhaps they were, but at least they were performed and the results released. It is my understanding that the results of the EU tests will not be released.

In emerging markets, the tests are not even being done. Most emerging markets are dominated by state owned banking institutions, where there are large political disincentives to revealing the level of toxic assets. The real truth about toxic assets will probably happen as more bad debts to western firms come out in the open although some of these, like Greentown bonds in China have been covered up by use of Chinese stimulus money.

The problem with inadequate information is that you cannot solve the problem unless you know the nature and extent. Many emerging markets have not even acknowledged the extent; they also do not have the legal infrastructure, a functioning bankruptcy system and fast foreclosure mechanisms, clean them up. As critics in the US have pointed out, if you do not clean up your toxic assets, you cannot expect sustainable economic growth.