Making sense of the fragile-five category of emerging-market laggards

Sid Verma
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Although market players discern substantial differences between the fragile-five economies – notably in their current-account profiles – they remain, as a group, especially vulnerable to domestic and international market shocks, says bearish analysts.

Checking out changes in the fragile-five emerging-market (EM) economies of Brazil, India, Indonesia, Turkey, and South Africa has become the default position for market players for the past year every time there is a new threat to the health of global markets.

This still makes sense, according to some of the more bearish EM analysts, who fear capital outflows, a lack of differentiation between credits and the diminishing boost to EM exports from a recovery in developed-world import demand.

All of these EM countries have one main dynamic in common: high current-account deficits that make them more dependent on foreign capital flows than others, and are consequently amongst the five hardest-hit EM currencies this year.

However, if this has been fully priced in, is there room for further depreciation in these currencies in the coming weeks and months?

One of the four key factors that prompted the recent mini blow up in the EM FX space as a whole – the tapering of the US Fed’s QE programme – looks set to continue to its ultimate conclusion. However, the second and third factors – ad hoc domestic risk blow-ups, and China tail-risks – remain largely unpredictable. As a result, the market focus is likely to remain on the fragile five’s current accounts, say analysts.

“Although over longer periods current accounts by themselves are not significant drivers of currency moves, they do become so in the shorter term when combined with other factors: specifically, in the EM space an overlay with broader risk aversion and, at this juncture, we may well be within one of those special episodes where the external position matters for EM countries,” says Jens Nordvig, head of global FX strategy for Nomura Securities International, New York.

“In this vein, current-account adjustments take time, and even if one of these currencies is down 15% to 20% over the past year [and more on a multi-year horizon], such as the ZAR, TRY, INR and IDR, the lag structure into trade performance is long, and, typically, the positive trade effect from a more competitive currency takes at least 12 months to kick into motion,” he adds.

Tom Levinson, FX strategist for ING, in London, says: “This sense that certain EM nations – among them, the fragile five – that have suffered of late have not made the necessary remedial action in recent years, during the good times, to correct such imbalances was evident from the world’s most advanced countries at the recent G20 meeting in Sydney.”

From a purely fundamentals point of view, the fragile five are less fragile than during the May-to-September taper tantrum thanks to resolute, although belated, monetary action, while flexible exchange rates have de-correlated FX markets from sovereign risk. The worry is that generalized EM pessimism will detract market players from substantial improvements, triggering a negative feedback loop through higher domestic rates and growth.

Nonetheless, says Ray Farris, head of Apac macroeconomic strategy for Credit Suisse, in Singapore, there are obvious differences between the fragile five that should serve to differentiate currency performance in circumstances in which general risk-averse sentiment is not heightened. This should be an obvious point, but many crossover investors and much of the media have been tempted to cast current-account deficit nations as akin to a correlated and homogenous asset class.

To start with, the current-account deficit is starting to correct in Brazil, has made substantial progress in India, whilst it is stuck in place in Indonesia, and remains at more than 5% of GDP in Turkey and South Africa – levels that in the past have precipitated currency crises.

In this context, he says, the rand also looks the relatively easier short against the US dollar from an interest-rates perspective, whilst in contrast policy tightening has been working to stabilize the real, rupiah, rupee and more recently the lira, relative to forward market pricing.

At a recent meeting of the Emerging Markets Trade Association in London, sell-side analysts and investors were sharply divided over the trading prospects of the five currencies, though they agreed valuations had largely overshoot fair value.

David Lubin, chief EM economist at Citi, says: “Current-account adjustment prospects in Turkey are much greater than in South Africa. Credit growth is decisive in generating the current-account deficit in Turkey compared with South Africa, so credit growth will go through the floor [in the former country], triggering a squeeze on domestic demand and that will close the deficit.

“But the import bill in South Africa is much more sticky, so it will be a challenge closing the deficit.”

Timothy Ash, head of EM research ex-Africa, at Standard Bank, warns that market calls for higher domestic rates in Turkey – to quickly engineer a reduction in domestic demand – could see Turkey enter a recession in the coming quarters. This could trigger a showdown between the government of prime minister Recep Tayyip Erdogan and the Central Bank of Turkey, which has previously delayed interest-rate hikes under apparent political pressure.