The recent rout of emerging markets prompt worries over a new emerging market crisis like those of the 1990s and early 2000s. While significant downside risks exist, differentiation is likely to take over as markets calm and investors pinpoint those countries with strong fundamentals and growth potential.
Emerging markets have had a difficult few weeks. Investors pulled more than $12 billion from emerging markets in January. Currencies, bonds, and equities markets have all taken serious hits. Both the World Bank and the IMF warned in January that emerging markets could see a sudden stop in capital flows, presenting serious downside risks to their economies.
Talk is brewing about whether we might be seeing the first stage of a new emerging market crisis, reminiscent of the Asian and Latin American crises in the late 1990s and early 2000s. There are four major global trends that underlie these fears.
First, the tapering of the Fed’s quantitative easing (QE) causes serious worries. QE provided cheap cash for emerging markets, as investors looked for higher yield outside developed markets. But this scheme is coming to an end – January’s purchases were $75 billion, down from $85 billion, and they will continue to be reduced further, moving down to $65 billion in February. This is causing a reversal in capital flows and a major withdrawal from emerging markets as yields rise in the West.
Second, poor economic data coming out of China is making investors nervous. Disappointing manufacturing data and developments in the shadow banking system were seen by some as the initial spark to this latest sell-off. The country has become more and more important to emerging markets over the last half decade, both as a driver of international growth and as a market for exports. China is still expected to grow more than 7% this year, but that is far less than in the past, and there are doubts about the sustainability of its growth over the next few years.
Third, the nature of current flows make the possibility of a crisis more acute, given the prevalence of “hot money.” There has been an explosion of Exchange Traded Funds (ETFs), which are highly liquid and update prices throughout the day, increasing trading volatility. The more speculative nature of these flows leaves emerging markets exposed to mass withdrawals. ETFs have amounted to three quarters of the outflows as of the end of January.
Fourth, global economic data has led some to question emerging market growth in the longer term. Investors have been shifting out of emerging markets since mid-2013, when the Fed first announced its taper, and there does not seem to be a clear catalyst to reverse this trend. The world economic recovery is still tepid, and without a faster-growing West that can act as a pull for emerging market goods there is little reason to expect, given China’s data, strong growth in these countries over the medium-term.
Reinforcing these global trends are localized political and economic issues that are increasing perceptions of risk.
In Turkey, the lira is plummeting as a political crisis is emerging over a corruption scandal involving the prime minister. And despite recent action, the fact that political pressure caused the central bank to delay making interest rate hikes is worrying. In South Africa, there has been a string of wage battles, most recently resulting in a worker strike at the world’s three largest platinum mines.
These two, plus India, Indonesia, and Brazil, have been dubbed the “Fragile Five” because they face fiscal and current account deficits, falling growth rates, above-target inflation, and political uncertainty from upcoming legislative and/or presidential elections. Five other significant emerging markets – Argentina, Venezuela, Ukraine, Hungary, and Thailand – also face some combination of political risk, loose fiscal policy, rising external imbalances, and sovereign risk.
These issues increase the tendency to treat emerging markets as a unified asset class. However, there are strong arguments that this does not have the signatures of a widespread panic, and that markets should stabilize in the coming weeks or months. The argument that differentiation is more prevalent this time around can already been seen in come of the market reactions.
So far, the currencies that have depreciated the most have generally been those with the worst market fundamentals. And some countries have managed to buck the trend. Mexico’s peso strengthened after several days of weakening against the dollar last week. Mexico’s economy is perceived as being fairly strong and reforming for the better. And since it is so closely tied to the US economy, good news there translates well.
South Korea and the Philippines, which are also seen to have reforming governments, have done all right. India, which was clobbered last summer, has a new boss for its central bank, who is trying to create a more unified monetary policy and has narrowed its current account deficit. It also performed better than most.
Emerging markets are also thought to be more resilient than they were before the last major crisis. Declining currencies can be problematic, but with a floating exchange rate, governments do not have to spend all their foreign exchange reserves to maintain an unsustainable rate. Most countries also have much larger reserve supplies, sounder banking systems, and lower public and private debt ratios than they did a decade and a half ago. We have not seen a major devaluation, a run on government debt, ratings downgrades, mass defaults, or a loss of countries’ access to the markets, either.
Looking back at last year’s emerging market turmoil, the sell-off of emerging market assets began very indiscriminately, but over time investors pinpointed those countries with real growth potential and credible economic institutions. The same thing is likely to happen this time.
Still, emerging markets used to get the benefit of the doubt, and it is likely that that age is over. This means that countries will have to buckle down to tougher economic reform, cutting back exposure to short-term debt and “hot money,” while making themselves more attractive to foreign investors by, first, raising interest rates, and second, by undertaking structural change to improve their growth potential.
