Making sense of the fragile-five category of emerging-market laggards
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.
Citi’s Lubin adds that the EM sentiment would likely to remain fragile amid challenges for capital flows and external demand. “The market is looking at their currencies and saying I will sell you because you have a current account [in South Africa and Turkey, principally] or because of weak growth, as in Brazil and Russia,” he says.
Craig Botham, EM economist at Schroders, says: “India was a classic textbook case in terms of policy tightening that will reduce the deficit. Indonesia is more a case of import compression, but it’s not a sign of an improving macro picture.
“In Brazil and South Africa, there has been little improvement despite weaker currencies. In Brazil, especially, no one wants to invest because of a lack of confidence and price controls.”
Nevertheless, there is a silver lining, adds Nomura’s Nordvig. Although cross-market correlations between FX moves and local rates moves are elevated in Brazil, India, Turkey and South Africa, in historical terms they still remain on the low side.
“This is important as, if FX moves happen independently of local rates, it is possible to actually generate further easing of financial conditions through FX depreciation, which will be supportive for growth, although it may delay current-account adjustments further,” he says.
Further differentiation is apparent by looking at the savings rates in the fragile five, says Patrick Lamaa, FX strategist for UBS, in London, as the lower the proportion of income being saved the longer it takes to make a country’s current account less dependent on the sentiment-driven vagaries of international investment flows.
“In this context, India and Indonesia have the best starting point, with savings rates of around 25%, whilst South Africa and Turkey have rates around the 12% to 13% level, and Brazil around 15%, which makes current-account deficits a much longer process to redress,” he says.
In UBS’s opinion, he adds, none of the fragile five offers value now, although none, equally, has a high chance of a balance-of-payments crisis any time soon.
For Nomura, as a corollary of its analysis of current-account dynamics, Indonesia and South Africa among the fragile five are relatively weak from an external balance perspective, along with Malaysia and Thailand, whilst Hungary, China, South Korea and Poland are stronger compared with their peers.
“Clearly, the current account is not the only variable that matters, and it is crucial to combine with other global factors, as well as additional domestic factors and, on the global front, we could remain in a period where external balances will matter more than normal,” concludes Nordvig.
“From this perspective, we are inclined to trade IDR, THB, MYR, ZAR and CLP from the short side in the coming months, and we may also look to trade BRL, TRY and RUB from the short side, albeit more opportunistically, given carry considerations.”
Another complicating factor for the fragile five is the potential for risk perception alterations resulting from political events domestically (see chart below) and from other EM flashpoints, notably at the moment including Argentina, Thailand, Turkey and Ukraine, among others, according to Win Thin, global head of emerging market currency strategy at Brown Brothers Harriman, in New York.
“The perceived receding of global capital flows has perhaps exposed and magnified the cracks in EM fundamentals, and these can be exacerbated by these flashpoints.”
Nevertheless, while it’s easy to overstate political risks in emerging markets, the reality is it’s only in Indonesia and India where an incumbent is not likely to win this year, allowing markets to position for the devil they know.