As rising US interest rates feed into a general deterioration of global markets’ sentiment towards emerging markets (as well as specific runs on the Argentine and Turkish currencies) the obvious question is: will this turn of the EM cycle be different?
In one immediate way, it undoubtedly is. And that is that journalists asking this question of bankers and investors should be ready for spiky reactions.
“Oh, is it that time in the cycle?” groaned one. “It’s out-dated, lazy journalism. Of course EM is solid. This isn’t 1982 or 1997. It’s 2018, and in every conceivable facet that matters, it’s completely different.”
Although tempted, I decided against provoking anyone any further and didn’t ask about potential contagion in Latin America from Argentina.
And I get it.
In my region, most countries have pretty open market economies. These are countries with free-floating currencies that absorb the pressure from a rising dollar. These are governments that finance mostly in local currency and have large FX reserves to cover dollar-denominated debt.
These are also economies with monetary space to execute counter-cyclical stimulus and (with notable exceptions) have narrow current account deficits. These are economies that, though still reliant on commodities in many cases, are nonetheless more diversified than in the past and more interconnected to global trading partners.
Those deeper local markets importantly also help dampen volatility. If and when EM investors decide to pull money, there is a local bid. This supports prices in two ways. It prevents precipitous falls – and awareness of that fact reduces the likelihood of a stampede at the first whiff of trouble because international investors aren’t afraid of being the last out of door.
Capital Economics research shows that the recent broad-based EM sell-off (all EM currencies weakened against the dollar in April – the only time this has happened since the ‘taper tantrum’ of May 2013) was much less acute than those driven by rising rates that occurred between 2013 and 2015.
That is recent history – go back further and it is clear that emerging markets are a lot less sensitive to shifts in US rates expectations and US treasuries.
To suggest that Argentina and Turkey will remain the exceptions that prove the rule is a bold call
So, yes, the chances of a widespread crisis in EM, with contagion spreading and shaking market after market as investors anticipate the next collapse, isn’t likely. But dollar strength is still a big risk; to pretend that a continuing strengthening in the greenback isn’t going to test EM markets in general is disingenuous.
Most obviously there is that corporate debt. A higher US dollar increases debt servicing and refinancing risks. Standard & Poor’s estimates that $225 billion of international capital markets debt from Latin America companies will mature by the end of 2022, and not all of it will be from export-based companies or managed by hedging programmes.
The ratings agency expects that borrowing costs will also rise; by an average of 100 basis points for investment-grade companies and 150bp for speculative-grade companies.
Combined with lower commodity prices (a higher US dollar should lead to a fall in commodity prices even though the inverse correlation with oil prices appears to have broken down), the higher debt costs will disincentivize investment. Fitch points out that, while weaker EM currencies can stimulate growth in the short term, in the medium term these positive GDP factors are outweighed by falling investment.
A rising dollar will stress EMs. To a lesser degree than in the past, certainly, and there won’t be a wave of contagion. But to suggest that Argentina and Turkey will remain the exceptions that prove the rule is a bold call. When the market began to lose confidence in Argentina it happened, like all crises, slowly at first and then all at once.
Glaring warning signs
Brazil certainly fits that bill. There are many good reasons to think Brazil is not near a crisis yet, but there are some glaring warning signs flashing ever brighter. Investors’ patience with the stubborn fiscal deficit has in many ways been incredible – and, as ever, the political situation seems far from supportive, both in terms of a potential market-credible president or any relief from a dysfunctional, fragmented system of government.
According to the IMF’s public debt sustainability analysis, the debt-to-GDP threshold, beyond which the risk of debt distress materially increases, is 70% for emerging and 85% for advanced economies. Brazil’s public-sector debt to GDP is 83% and rising – the highest in the EM.
More generally, should the dollar continue to rise, EM asset prices will be negatively impacted and the easy days of abundant liquidity and super-low pricing for international capital flows will be reversed. Weak spots will be stress-tested.
Maybe that is why finance people really don’t like the question. Perhaps it is a harder, more nuanced question. I suspect that the much vaunted “differentiation” that was supposed to feed into EM performance after the taper tantrum – and didn’t really materialize – might be more evident on the downside. If that is true, then the range of EM portfolio returns will be larger in the coming years and performance will be more scrutinized.
In which case one of the biggest tests will be for those financing EM. And to pretend a test isn’t coming risks failure before it really starts.