Rough ride in store for EM currencies; Pace of forex reserve drawdowns to rise for vulnerable economies

October 21, 2013 6:04 am

Rough ride in store for EM currencies

By Mark Haefele

Pace of forex reserve drawdowns to rise for vulnerable economies

Recent pressure on emerging market currencies has rightfully made headlines. But the broader issue for emerging markets is that such episodes could easily reoccur, or even get worse, over the next few years. This is because, over the past decade, these economies have increasingly pinned their economic hopes to foreign capital flows. The numbers speak for themselves; portfolio flows to the emerging markets have grown 400 per cent over the past 10 years, compared with nominal GDP growth of 200 per cent. And the same is true of the broader private capital measure, which also includes bank lending and direct investment. This has increased 5.5 times over the same period.This increase in flows relative to GDP means capital withdrawals are now particularly painful in times of stress. Repeatedly, we have seen that investors’ fear of the unfamiliar results in a herd mentality, repatriating capital to more familiar domestic markets.

In the coming years it means investors will need to keep an eye on those economies most vulnerable to this dynamic. As we have seen recently, so-called “double deficit” countries, those with both a fiscal and a current account deficit, will be highly exposed; and necessary but growth-retarding policies, such as interest rate hikes, will become more common and of a larger magnitude.

For those vulnerable economies, the pace of foreign exchange reserve drawdowns will also increase, and investors will need to watch where buffers are dwindling to spot a potential currency crisis.

But while the increase in flows will exacerbate volatility in the coming years, we envisage a “J-curve” development: cross-border capital linkages will eventually reach a tipping point where foreign investments and relations are so entrenched that the urge to flee for home in times of stress recedes.

Tipping point

The question then arises of how and when the tipping point in capital flow dynamics will be reached. Predicting an exact date would be folly, but we can identify a few necessary precursors.

First, emerging markets will need to increase their listed market capitalisation. Currently emerging markets account for almost half of global GDP but less than 15 per cent of the MSCI All-Share Index. This means, at present, financial market investors do not face a major performance risk relative to their benchmark when they flee for home. A larger market representation would change this behaviour.

To make this happen emerging markets will need to continue growing, but also liberalise their economies and privatise state industries.

Another necessary condition for the broader flow of private capital is greater financial integration. The rise of an emerging market currency to challenge the US dollar would clearly help.

The most likely candidate is the Chinese renminbi, whose government has now signed currency swap lines with 22 countries worldwide. Many predict that by the middle of the decade the renminbi will be one of the top three global trade currencies.

Finally, an increase of developed market corporate physical relocations to the emerging markets, in order to be closer to growth markets, should reduce the desire to extract capital in times of stress.

This trend is already occurring: according to a 2013 survey by the Economist, in the past four years the percentage of western companies with “senior management” in Asia has doubled.

In addition, emerging market lending by developed market institutions is increasingly conducted via local subsidiaries, making it less vulnerable to withdrawal.

Distant prospect

Unfortunately, all of these factors playing out remains a distant prospect. Emerging economies such as Chile and Korea have expanded market capitalisation in excess of gross domestic product, but the largest emerging market economies – China, India, Brazil and Russia – remain below developed market averages.

Moreover, China’s ability to run a global reserve currency will depend on its ability to transition away from an export-led economy, a process that is likely to take decades.

In the meantime, the impact of emerging market capital outflows will get worse before it gets better, and investors will need to remain more watchful of those “double deficit” countries.

But once all three drivers are in place, emerging and developed economies will become intertwined closely enough to eliminate the herd mentality of capital repatriation in time of stress.

As a result, emerging markets’ volatility will reliably fall in line with that of developed markets.

Mark Haefele is global head of investment at UBS Wealth Management; James Purcell, cross asset analyst, is co-writer