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Emerging markets: navigating uncharted territories

 

The essential

  • A more challenging global financial environment is putting pressure on EM risky assets with particular impact in some segments (Local Currency) 
  • EM Markets are still very dependent not only on global financial conditions but even on global demand.
  • EM Monetary Policy is shifting towards a tighter stance further penalising domestic economic cycles
  • External vulnerability has reduced in the years but the conditions are very heterogeneous among different countries
  • Three cases of vulnerability: Brazil, Turkey and Argentina

 

 

Flag-UK

July 2018

Flag-FR

Juillet 2018

 

Since the beginning of the year, emerging market risky assets have become more volatile. Segments like local currencies have performed poorly (YtD -6.8% as of the 21st of June), due to a strong USD that has finally emerged, along with the Federal Reserve’s pursuing its monetary policy normalization process. Flexible exchange rates are acting as a shock absorber, and they should allow economies to adjust, provided that sufficient buffers are there to prevent disorderly developments. However, the level of stress expressed in the financial markets is not comparable to that of past crisis events (based on the portfolio outflows and CDS widening) and there is still some appetite for EM assets. This reflects a combination of still appealing relative returns, together with the view of improved fundamentals within the asset class, barring any further disruptive scenario in terms of trade war and unexpected/uncontrolled monetary policy actions by the main central banks. This has been partially visible as far as Asian markets are concerned.

Indeed, current positive fundamentals and constructive macroeconomic conditions should not conceal the fact that emerging market countries are still very dependent on external demand. EM aggregate profits growth is very closely correlated with EM exports performance. Different dynamics in terms of commodity prices or the manufacturing cycle can shift the growth premium in favour of commodity or manufacturing producers, simply making a growth re-distribution.

However, that doesn’t change the relevance that external demand overall holds for EMs. Very few countries have been able in recent years to re-engineer their economic model from an economy mainly externally driven to one driven by domestic demand with proper governance shared between monetary and fiscal authorities and a virtuous and sustainable allocation between labour income and profits. China may be the only country slowly planning and succeeding in such a transition.

Together with external demand being threatened by the current developments in world trade, there is another potentially negative aspect to impact the domestic economic cycle: EM monetary policy stance is turning more hawkish than expected at the beginning of the year. Global financial conditions are still accommodative but are tightening marginally and some EM central banks have started to react, increasing policy rates. Monetary policy stimulus reduction will occur alongside EM economic cycle stabilization and cooling down.

External vulnerability

Since April, USD has been appreciating versus EUR on the back of different factors:

  1. stronger macroeconomic momentum in the US in comparison with the euro area;
  2.  a divergent inflation path, with US inflation rising to the target, while euro inflation is struggling to pick up (core CPI mainly);
  3.  a less synchronized monetary policy, with the Federal Reserve more hawkish than ECB;
  4. a greater awareness of political/geopolitical risks around the world.

Since 2013 (and the taper tantrum episode), external vulnerability has declined in emerging market countries. Basic balances have generally narrowed, with very few exceptions. The countries then called the “fragile five” (Brazil, India, Indonesia, Turkey and South Africa) have mostly adjusted their external unbalances. In that respect, only Turkey and partially South Africa are as vulnerable as they were in 2013. The current account deficits of commodity importers like Turkey and India have recently widened further on the back of higher oil prices.

The huge increase in capital inflows in recent years has helped build reserve buffers to be used during periods of strong volatility. Different measures of reserves adequacy ratios (such as import cover and reserves on short-term external debt) have been improving, with some exceptions.

In the most recent financial turmoil, the markets at first went after the most vulnerable countries on the external side: Argentina and Turkey (see Boxes). Since Q2 2013, Turkey’s current account deficit has risen from 5.8% of GDP
to 6.3% in Q1 2018, with FDI stable at 0.8% of GDP, not enough to adequately fund the deficit; reserves adequacy ratios are very poor with 4M of Import Cover and a 0.7% ratio of reserves on short-term external debt. Argentina has a strong dependency on foreign flows: PTF investments came to 8% of GDP in 2017 and are now down to 6.4% (Q4 2017) while the current account deficit went from 0.9% of GDP in Q2 2013 to 4.9% in Q4 2017. Then the pressure increased in other countries exposing very great fragility, like the fiscal position i EM (ex‐China) Months of Import Cover n Brazil (see Box).

2018-07-Cross-Asset-Invt-Strategy-fig-1

Banks & financial vulnerability

Since the global financial crisis, banking regulation has increased worldwide, balance sheet leverage has been reduced, capital requirements have increased, and liquidity is more strictly regulated. Unlike past crisis episodes, the EM banking sector is less dependent on a common global/foreign lender and local banks are more domestically/ regionally oriented, which could lower the risk of a local event degenerating in a global crisis. On the other hand, EM banks have been increasing their relevance globally.

Dollarization risk (FX risk) has fallen somehow since the global financial crisis and even more so since the 2015 CNY depreciation but is still substantial. Good practices since then have significantly reduced lending to households and increased hedging on the corporate side, thanks to macro prudential policies dictated by central banks in some EM countries. On top of that, FX corporate lending has been targeting more and more companies with USD revenues. However, keep in mind that the actual size of FX risk is uncertain. Our perception of a reduction in risk comes from a bottom-up analysis at the level of companies and banks.

 

2018-07-Cross-Asset-Invt-Strategy-fig-2
2018-07-Cross-Asset-Invt-Strategy-fig-3
2018-07-Cross-Asset-Invt-Strategy-fig-4
BERARDI Alessia , Senior Economist
HERVE Karine , PhD, Senior Economist
VARTANESYAN Sosi , Strategy and Economic Research – Paris
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Emerging markets: navigating uncharted territories
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