21 February 2014

Emerging Market Rout

​The cue seems to have been the Federal Reserve’s long-awaited decision to scale back its monthly bond-buying programme. Over the last two months the bank ha...

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The cue seems to have been the Federal Reserve’s long-awaited decision to scale back its monthly bond-buying programme. Over the last two months the bank has reduced asset purchases from $85 billion a month to $65 billion.

As we saw last year when the then Fed chairman Ben Bernanke first hinted at tapering, even the prospect of the central bank dialling back quantitative easing can send emerging markets into a spin.

This time around the impact has been no less severe on emerging markets, with shares and currencies tumbling.

The Argentine peso and Russian rouble have both taken a battering, while the pressure on emerging markets has forced central banks in Turkey, India and South Africa to hike rates to stem the flood.

Turkey announced a massive rate rise, more than doubling its benchmark to ten per cent, while the Reserve Bank of India (RBI) increased its base rate from 7.75 percent to eight per cent, ostensibly in a bid to cool inflation.

South Africa lifted its rate to 5.5 percent from 5 percent, with Reserve Bank governor Gill Marcus saying "the depreciation of the rand exchange rate" was the main driver behind the decision. ZAR has lost 25 percent to the dollar in the last eight months and is at a five-year low.

The global financial crisis, she added, was "creating new challenges for emerging market economies" as it enters a “new phase”.

Certainly the end of cheap money from the Fed has been a catalyst for the capital flight.

As tapering sends US interest rates higher, emerging market debt is less attractive. The carry on emerging market government bonds is no longer sufficient to match the risk. This gets made worse as falling exchange rates swell declines in bond and stock prices.

RBI boss Raghuram Rajan has even gone as far as blaming US monetary policy, specifically tapering, for the rout in emerging markets.

But the Fed’s monetary policy is far from the only game in town. The bank is still pumping large amounts - $65 billion a month- into the economy for a start. Tapering is not anywhere close to tightening. Moreover, worries about a credit bubble in China are causing anxiety in the markets, while the very actions of some central banks is a concern.

Large current account deficits are the biggest risk. “The countries that are under the greatest pressure are also the countries with the worst economic balances, and India should know better than just to point a finger at the Federal Reserve,” says Teis Knuthsen, CIO at Saxo Private Bank.

Interest rate smoke and mirrors 

Credibility - as Mark Carney is finding out in the UK - is vital when it comes to central bank actions, and Turkey’s massive 425 basis point hike in rates on January 28th seemed to suggest panic.

Following the announcement USDTRY was “untradable” for a couple of minutes, before we saw things settled down as you would expect, with the interest rate rise strongly positive for the TRY.

However, it did not take long for those gains to unwind as the “political and systemic risk” endemic to Turkey resurfaced above the temporary central bank polish.

As Ken Veksler from Acumen Management suggests, this is nothing more than a “band aid solution, a stop-gap of sorts, that will do nothing in the medium and longer term to shore up a problem that transcends the healing scope of monetary policy”.

But do the current problems for emerging markets (EM) suggest we are in for a repeat, for example, of the 1997/8 Asian and Russian crisis?

It’s important first to remember that not all emerging markets are alike. Turkey, South Africa, Chile and Peru have all been running large current account deficits and are therefore the most at risk of the capital flight caused by the Fed taper and the growing anxiety surrounding the EM sector in general.

For Steen Jakobsen, chief economist and CIO at Saxo Bank, the crisis is not going to go away. “If anything, it will probably get worse before markets and currencies across EM find a new and probably much lower equilibrium,” he says.

Jakobsen agrees that lifting rates does not matter in the long run when there are more deep-seated issues at stake.

Higher short-term interest rates simply “hurt their bonds, their equity markets and, ultimately, also their currencies”, he says.

But that might not stop others from following suit. Indonesia’s rupiah has been under pressure and it could be the next to hike rates. Brazil and Russia may also have to lift rates as a result of currency weakness.

The issue for Jakobsen is that emerging market central banks are now actively pursuing lower growth and weaker currencies to slow imports and increase exports, which in turn penalises EM investors.

“When policymakers signal they will allow weaker currencies forward, then by definition the last place you want to invest is in EMs,” he adds.

For Jakobsen, this rout in emerging markets is simply the third and final phase of the global financial crisis.

In Saxo Bank’s yearly ‘Outrageous Predictions’ John Hardy, Head of Forex Strategy at Saxo Bank, predicted that the Fragile Five - Brazil, India, South Africa, Indonesia and Turkey - would see their currencies fall 25 per cent against the US dollar in 2014.

Given the recent declines in EM currencies and the positioning in the markets at present, this prediction may not be as outrageous as thought.

As Jakobsen points out, countries running large current account deficits that hike rates are in trouble.

“Panic short-term money market hikes are a sign of weakness, not strength, and play into the hands of investors who are shorting EM,” he says. 

Turkey, India and South Africa have already signalled their weakness with rate rises - could Brazil and Indonesia be the next EM dominos to fall?


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The value of your investments can go down as well as up.
Losses can exceed deposits on margin products. Please ensure you understand the risks.