Firstly, the China bailout of emerging markets is over. The IMF forecasts it will expand 7.1% in 2015, the lowest rate of growth since 1990. A slowing China combined with a strengthening dollar heralds a new normal for emerging markets, hitherto buttressed by cheap dollars and the Asian nation’s voracious commodity-import demand.
Secondly, post-crisis central bankers convinced market participants that money-printing by itself would seed an economic recovery, justifying the push to bring forward future gains in asset prices. The subsequent sharp fall in real bond yields re-rated stocks and risk assets, more generally, including EM.
But a stronger dollar, accompanied by higher US yields, has made the EM carry trade less attractive, just as global markets are re-assessing the disconnect between economic fundamentals and valuations of risk assets.
A strong dollar should boost the relative competitiveness of EMs with large export exposure to the US, such as Mexico. While ECB and Bank of Japan liquidity should help to boost EM local markets and FX, it’s not clear if the euro and yen will replace the USD as favoured funding sources for carry trades, since real money EM investors are traditionally a dollar-focused investor base.
Investors and bankers could be caught out by the underperformance of dollar-denominated debt relative to the long-end of local credits, especially in markets that are set to benefit from the ECB’s monetary expansion, such as Poland and Hungary. With lower post-crisis inventory levels, and EM FX caught between a stronger dollar and weaker growth, market volatility seems inevitable, aside from the obvious basket cases of Ukraine, Venezuela, and Russia.
Thirdly, the vulnerability of emerging markets, as a group, is a world away from the May 2013 taper tantrum thanks to smaller trade deficits, higher real rates and weaker currencies in general. But the latest macro challenge pits the commodity exporters, Brazil, South Africa and Indonesia, against the manufactured goods exporters, including India and Turkey, with the latter group staging a stronger adjustment in current accounts.
As a result, the 20% fall in oil prices in recent months will trouble EM producers – one of the bright spots in the EM basket in recent years – across the board. Emerging Asia, as a net commodity importer, will benefit from lower oil prices. According to Deutsche Bank, the Brent spot price (a drop under $85 as Euromoney goes to press) is below the level needed to balance the budget in Bahrain ($136), Oman ($101), Saudi Arabia ($99), Nigeria ($126), Russia ($100) and Venezuela ($162). While the likes of Saudi and Russia have meaningful fiscal cushions, compared with Nigeria and Venezuela, the death of the commodity super-cycle will constrain EM liquidity.
What’s more, although on the surface, the oil sector has declined as a proportion of real GDP in key producers, such as Nigeria, it has been key in financing imports and government spending. In the absence of an oil surplus, government spending – with a high fiscal multiplier – falls, interest rates rise, local currencies without pegs devalue and slowing economies will be forced to rely on volatile portfolio flows to finance any deficits.
Across emerging markets, lower oil prices should prompt governments to enact structural supply-side reforms to ensure household income and spending growth can be sustained by gains in productivity, rather than in oil revenue.
The consequences of this new normal for emerging markets will be dramatic and uneven.