Emerging markets have been fairly resilient since the brief panic that started in late January but the game is surely up.
International investors bought into these markets in the wake of the global financial crisis when they were the only source of growth in a stagnant world economy. Yields in developed markets had been squashed to zero to stimulate economic activity, while emerging markets were still offering solid returns based on relatively sound fundamentals. The trade was a no-brainer: buy EM equity and debt.
Needless to say, banks and companies from Argentina to Vietnam have been happy to oblige by borrowing at least $1.5 trillion in external debt during the past four years.
But this carry trade is now unwinding as the US Federal Reserve tapers its monthly asset purchases, much to the annoyance of policymakers in emerging markets, who see the Fed’s actions as destabilising and selfish.
“International monetary cooperation has broken down,” said Raghuram Rajan, governor of the Reserve Bank of India, on Bloomberg TV in January. “Industrial countries have to play a part in restoring that, and they can’t at this point wash their hands off [it] and say we’ll do what we need to [do] and you do the adjustment.”
These comments were clearly made for domestic consumption but one thing is true: the EM adjustment will be painful.
The correction in EM stocks seen at the start of the year wiped 4% off their value in just a week. It was followed by an equally sharp rebound the week after. Asian EM shares have been choppy this week, rebounding slightly on Tuesday.
Such jittery trading is likely to become more prevalent this year.
The growing instability is not just economic. The recovery in EM equities has taken place even as alarming scenes of violence play out on the streets of Venezuela and Ukraine — and also in Asia, where Yingluck Shinawatra, Thailand’s prime minister, was forced into hiding by opposition activists in Bangkok.
News images of people being shot on these streets are scary enough but investors are even more worried about several other EM markets, namely: India, Indonesia, Brazil, Turkey and South Africa, plus the more recent additions of Argentina, Russia and Chile — the so-called Fragile Eight.
Asia not immune
In Asia, there is a tendency to believe that the lessons learnt as a result of the financial crisis of 1997 have helped the region to avoid the worst effects of the global financial crisis — and will continue to be effective this time around. After all, the Asian crisis was sparked by capital outflows and most countries in the region have responded by cutting overseas government debt and allowing their currencies more room to move. What can go wrong?
India is finding out. In the wake of the 2008 crisis, Indian politicians relied on abundant global liquidity to run current account deficits and suppress inflation but the removal of that liquidity is already putting the rupee under pressure and has led to significant interest rate hikes since last August — with one-year rates up from 5.1% last August to 6.35% in late February this year, according to Bloomberg.
That is still less frightening than Turkey’s 550 basis points hike in late January but it is enough to derail the domestic credit cycle and plunge India into a period of slow economic growth and higher inflation.
Indonesia has a different set of problems. A few years back the combination of strong global liquidity and a rising commodity cycle made it easy for the country’s leaders to deliver robust economic growth but the reversal of both trends has done the opposite. Interest rates have risen more than 200bp since June last year.
As liquidity continues to flow back to the US through tapering, the stress on these countries is only likely to get worse.
Asia’s belief that foreign borrowing is no longer a problem may also come unstuck. Overseas debt has accumulated at banks and corporates, rather than on the government account, and doesn’t show up in external borrowing numbers when a company sells dollar bonds through an offshore subsidiary, such as the Hong Kong-listed unit of a Chinese company.
These debts could still cause problems. In a paper published last year, Hyun Song Shin, an economist at Princeton University, identified the following sequence of “crisis dynamics” for emerging economies:
1. Steepening of local currency yield curve.
2. Currency depreciation, corporate distress and runs of wholesale corporate deposits from the domestic banking system.
3. Decline in corporate capital expenditure feeding directly into a slowdown in economic growth.
4. Asset managers cutting back positions in emerging-market corporate bonds, citing slower growth in the emerging economies.
5. And then back to Step 1, thereby completing the loop.
Interestingly, Shin’s crisis scenario doesn’t directly invoke bankers — unlike most other financial crises this one is not obviously caused by excessive leverage or a maturity mismatch. The bad guys here are asset managers.
“The uncomfortable lesson is that asset managers may not conform to the textbook picture of long-term investors but instead may have much in common with banks in amplifying shocks,” wrote Shin, who argued that trading restrictions at asset management firms are ultimately based on the same kind of risk measures used by banks and other leveraged players.
In other words a panic in emerging markets on one side of the world now has the potential to wreak havoc across all emerging markets, as global asset managers shuffle their portfolios to cover losses or cut risk. Can’t sell Turkey, try Indonesia. That is a recipe for contagion that should worry politicians across Asia.
