Any hopes that emerging markets could somehow ring fence themselves from the eurozone debt crisis and the misery of the US economy have been unequivocally shattered this month. Forget it.
More specifically, it is their currencies that have suffered a rout, justifying the decisions of many central banks to build up their foreign exchange reserves in recent years.
Global emerging stock markets (GEMs) have slumped by almost 18% in September, which is the worst monthly decline since October 2008, according to a Citi research report issued this week. And, given "the savage unwinding of the emerging market carry trade", over 40% of that collapse is due to foreign exchange weakness, the bank says.
The authors of the report, led by Geoffrey Dennis, attribute the falls to a combination of the shock interest rate cut by Brazil’s central bank on August 30, the rebound of the US dollar against the euro, and the official cap placed on the Swiss franc/euro cross-rate.
The Brazilian real, with the highest interest rates (12%) in the emerging market world, had been a very popular carry trade for investors, and then unexpectedly the central bank seemed to be signalling a desire for a weaker currency.
The other two factors further underpinned dollar strength, and hastened the unwinding of vast volumes of carry trades in other high-beta currencies, as investors scampered to book profits or alleviate losses.
“The flight back to the dollar has sucked liquidity out of the emerging markets,” said Dennis. And currency weakness is likely to continue as foreign investors jettison their holdings in local debt markets.
At the beginning of the summer, when emerging market equities started to sell off, their currencies held up pretty well, accounting for less than 20% of the falls in July and August. Their resilience, shared by emerging market sovereign bond yields, was unusual at a time of equity market weakness. It suggested no crisis at all in emerging markets, said Dennis.
That changed in September. Emerging market “currencies have collapsed so far this month, exacerbating losses for equity investors and creating something of a panic atmosphere on several occasions in recent weeks”.
MSCI GEMs are now down by 26% year-to-date, and suffered a 6.3% drop on one day alone – on September 22. Using equity weights to create an emerging market proxy index, Citi calculates that the average fall in currencies this month has been 8%, even though the Chinese renminbi -- the biggest weight in the index -- has been more or less flat against the dollar.
The issue now is whether a period of dollar strength will have a deleterious effect on the longer-term performance of emerging market equities.
The Citi team point out that equities are negatively impacted by a rising dollar for several key reasons.
First, a strong dollar pulls cash out of emerging markets and usually causes risk aversion to increase. Second, it causes corporate earnings and the return on equities to decline. Third, it typically translates into weaker commodity prices, which are harmful for the net commodity-exporting emerging world. And, finally, it imposes negative translation effects on foreign holdings of emerging market equities.
Asian markets have been historically most vulnerable during periods of dollar strength – although the year-to-date fall of 25.8% in MSCI EM Asia in dollar terms is no worse than the MSCI indices for Latin America and Emea.
Citi concludes on a more sanguine note, with a tentative view that the “carry trade unwind in emerging markets may already largely be over.”
If so, then arguably emerging markets, having been ditched by foreign speculative investors, might be in better shape to withstand the next inevitable stages of the European and US crises.