Are Emerging Markets Heading For A Crunch?

The data should reassure investors that the end of QE in the U.S. and the rise of the dollar are unlikely to trigger a liquidity crisis  

Reviewed by: Biola Babawale
Edited by: Biola Babawale

Conventional wisdom says that weak commodity prices and a strong U.S. dollar spell difficult times for emerging markets. Those who like conventional wisdom, or who see emerging markets as an homogenous set of economies, might like to consider the following data.

In the 12 months to mid-May 2015, the MSCI China Index rose 52 percent, while the MSCI Brazil was down 18.2 percent. The MSCI India was up 16 percent, while the MSCI Turkey was down 3.4 percent. The explanation for this wide divergence is complex and at this point probably not fully understood. But whatever might be on the list of things about to happen, an all-encompassing ‘emerging markets currency crisis’ is not likely to be near the top.

Exchange Rate Havoc

Emerging markets certainly face a number of difficulties. The winding down of quantitative easing by the Federal Reserve has reinforced the expectation that U.S. yields will rise. This has been sufficient to reduce demand for higher-risk emerging market assets, to the extent that in the second half of 2014 the 15 largest emerging economies saw the biggest absolute capital outflows since the currency crisis in 1997/98.

The winding down of QE and the prospect of higher U.S. yields fed quickly into the exchange rate, strengthening the U.S. dollar. This creates an added burden on ‘deficit countries’, who are dependent on international lenders to finance public spending, domestic credit markets or net imports. Weaker national currencies further increase the risk of inflation by pushing up the price of imports. This pass-through is evident in several countries despite being dampened by low oil prices. On the flip-side, a stronger dollar makes emerging market exports relatively cheaper for U.S. consumers.

Winners And Losers Of Weak Commodities

Similarly, weak commodity prices harm some and benefit others. The worst affected are exporters that are less diversified. In Russia, a fall in commodity prices is likely to inhibit real GDP growth far more than in India, a nation less dependent on commodity exports. Other markets, such as Turkey, a net commodity importer, should benefit from lower prices.

The key to resilience, however, is monetary. There has been considerable progress since the 1990s, when several of the largest emerging economies had a hard peg to the dollar, including Russia, Brazil, Mexico and South Korea. These have all gone now, allowing authorities to let the stress of interest rate and liquidity differentials channel through a floating exchange rate. In a number of cases, allowing a national currency effectively to devalue has improved competitiveness, boosted current accounts and relieved pressure on fiscal subsidies.

In absolute U.S. dollar terms, external debt among emerging and developing economies has risen sharply since the currency crises of 1997/98, from around $2.5 trillion to $7.5 trillion. But the ratio of external debt to GDP has been falling, from 36 percent in 1990 to 25 percent in 2013. Looking at those markets that suffered currency crises in the 1990s, only two, Hungary and Malaysia, have external debt to GDP ratios above 50 percent, while the ratio of external debt service to exports is also generally positive, with only Hungary above 50 percent.

Compare these figures with the G7, where gross public debt is $40 trillion, 117 percent of GDP, up from 75 percent of GDP in 2001.

Beware EM Corporate Debt

If this sounds a bit too good to be true, it’s possibly because it is. While public finances are broadly robust, there has been a marked rise in corporate debt, much of it dollar-denominated. The concern here is not merely the total amount, which is difficult to quantify, but the diversity of lenders, including parent companies, banks and bond investors. In addition, the domestic investor base in emerging markets tends to be narrow, particularly in sectors offering stable investment horizons, such as pensions and insurance. While the capital outflows seen in emerging markets are unlikely to trigger a liquidity crisis, access to capital may inhibit future growth potential.

Taking Steps To Reform

There is a solid core of emerging markets that are proactively improving their public finances. Mexico, for example, has been broadening its tax base beyond oil and allowing the state oil company, Pemex, to work with a broader range of private sector partners. Indonesia has taken advantage of lower oil prices to remove fiscally destabilising fuel subsidies. Colombia has eased oil industry regulation and used its weaker currency and free-trade agreements to expand manufacturing.

Those that resist taking steps to reform are often forced to act. Brazil is facing the double whammy of fiscal tightening and higher rates - with the payoff of falling demand limiting inflation pass-through from the weaker currency and higher regulated prices. Russia is tightening fiscal and monetary policy and there's even talk in the finance ministry of using this as an opportunity to push through unpopular reforms such as increasing the retirement age.

Emerging markets face other headwinds which may in time prove more or less important, the most obvious on the current outlook being the slower growth rate in China. But for now, the data should reassure investors that the end of QE in the U.S. and the rise of the dollar are unlikely to trigger a liquidity crisis.

Biola Babawale is an economist at Vanguard Europe