Emerging-market rout: this time it’s personal
Emerging-market assets have fallen thanks to domestic policy risks, rather than Fed-tapering fears, triggering market contagion, as Turkey and Argentina lurched into crisis mode. However, India’s economic rebalancing shows the way forward for EMs out-of-market favour.
Here’s how you screw up current-account adjustment: seek to engineer a reduction in domestic demand through local-currency depreciation, rather than interest-rate hikes, introduce uncertainty and event-risk to monetary policy, and blame the Fed and speculators when your currency collapses and asset prices fall precipitously.
Turkey and Argentina – two distinct economies, with the former boasting much stronger policy fundamentals – have trod down the aforementioned path in recent months, seeking a gradual approach to correcting imbalances with mixed policy messages.
The result: their respective currencies fell to historic lows during the past week amid a lack of market confidence, triggering panic-selling, with usually resilient currencies, such as the Korean won and Polish zloty, coming under pressure.
The fear is that such localized policy errors will exacerbate the generalized rout thanks to the prejudice of cross-over investors, who cast emerging markets (EMs) as a correlated asset class, prone to economic mismanagement, say analysts.
In Turkey, the central bank has engaged in a dance of hiking-in-disguise to avoid the political fallout. On January 21, the central bank kept benchmark short-term policy rates unchanged despite huge pressures on the currency.
Instead, the central bank said it would make sure interbank money-market interest rates will be set at around 9% for “the additional monetary tightening days”, making it unclear whether it would, in practice, deliver tighter liquidity needed to drive up market rates.
In other words, instead of hiking rates to contain currency depreciation, the central bank helped to increase volatility in rates and asset prices through ambiguous messaging.
Amid the market fallout, the emergency central-bank meeting on Tuesday, with a statement expected at 22.00 GMT, suggests authorities understand the importance of a tighter monetary policy to contain precipitous lira depreciation.
Argentina is another case in point, where the government is beginning to capitulate. Last week, the cabinet chief Jorge Capitanich announced some controls on purchasing dollars would be relaxed – for saving purposes – and interest rates would rise by as a much as 6% at this week’s auction of peso-denominated bonds.
The policy efforts aim to contain inflation and reduce demand for dollars at the parallel exchange rate, where a wide spread to the official rate reflects distrust in the local currency thanks to the government’s inflationary zeal in recent years.
However, there were mixed signals on the scope of the new foreign-exchange rules while the economy minister reiterated the government’s expansionary policy. Argentina’s heterodox economic policies are well known and the economy is not included in the fashionable moniker of the fragile five, markets said to be vulnerable to Fed tapering, comprising Indonesia, South Africa, Brazil, Turkey and India.
Instead, Argentina’s latest missteps, like Turkey, underscore the importance of domestic factors in triggering the recent EM downtrend, rather than Fed-tapering fears.
Sébastien Barbé, head of EM research at Crédit Agricole CIB, says although there is a “broad consensus that Argentina is a case apart”, the panic-selling last week in response highlights the fragility of market sentiment.
“The central bank likely decided to devalue because the depletion of FX reserves was becoming unsustainable,” he says. “This rings bells. The fragile five [TRY, ZAR, BRL, INR and IDR], after all, have also generated worries because of balance-of-payment and external-liquidity issues, in particular.
“Should the market move into panic mode, then liquidity fears generated by Argentina could continue to spread to the fragile five.”
By contrast, amid a temptation among EM central bankers to suggest the interest-rate policy tool is not a particularly effective real-economy mechanism, India highlights how resolute monetary policy action, together with fiscal measures, can deliver current-account rebalancing, rebuilding market trust.
Notes Shweta Singh, EM economist at Lombard Street Research: “A proactive monetary policy stance, a slew of macro-prudential measures and the gradual impact of structural reforms announced earlier helped India address high volatility and huge sell off last year.”
The Reserve Bank of India (RBI) raised the effective policy rate by 200 basis points in August alone, interbank call money rates jumped by 360bp during July to September and the RBI introduced quantitative measures to reduce liquidity, along with restrictions on gold purchases to reduce India’s import bill.
As a result, the economy has undergone massive rebalancing compared with the other members of the fragile five.
Source: Haver Analytics
India’s gradual rehabilitation in the eyes of global markets means it is being excluded from the fragile-five moniker, with Russia taking its place.
Source: Haver Analytics
A second-leg of the generalized EM weakness – after a bear market last summer, triggered by Fed tapering fears – is to be expected, writes Mark Dow, a former IMF economist, hedge fund manager and financial blogger.
“Valuations won’t matter until we can tell a compelling growth story and too many EM countries have to work through all the domestic debt they built up during boom,” he says. “Currency spasms and deleveraging raise the risk of policy errors in certain cases.”
Dow adds: “People will overstate how bad fundamentals are as price action worsens, and tourists (crossover investors), who are in control of the flows, will mostly revert to old school EM biases, even though many things, fundamentally, are different (better) this time.”
The following chart highlights how from mid-January EM FX weakness is down to endogenous reasons, in contrast to May to December when expected shifts in US monetary policy drove EM FX moves.
Expect valuations to decouple from fundamentals before growth-narratives are restored:
This will be the case especially in economies with large financing requirements, which for fans of over-laboured neologism, applies to the True (Turkey, Romania, Ukraine and Egypt) countries, in particular.