‘Fragile Five’ Struggle to Take Advantage of Fed Taper Reprieve

November 13, 2013, 3:49 AM

‘Fragile Five’ Struggle to Take Advantage of Fed Taper Reprieve

NATASHA BRERETON-FUKUI

The Federal Reserve’s decision in September to maintain for now its extraordinary support for the American economy has given emerging markets extra time to prepare for the U.S. central bank’s eventual policy tightening. The verdict is mixed on whether the “Fragile Five” — as Morgan Stanley dubbed India, Indonesia, Turkey, Brazil and South Africa – have done enough to prepare for the Fed’s eventual tapering, which some analysts now believe could come  as early as December.Indonesia’s surprise move Tuesday to raise interest rates — its third raise since August – shows the depth of concern over a yawning current-account deficit that hastened investors’ rush for the exit this summer. Benchmark rates in Jakarta are now a full percentage point higher than they were when tapering worries mounted in May.

But that’s not all: In June the government took the politically sensitive step of cutting fuel subsidies to pare its budget deficit, and in August said it would raise taxes on imported luxury cars and other goods and discourage oil imports.

Yet that has failed to boost the rupiah currency, which has missed a recent bounce in emerging-market currencies and is down around 17% from the start of the year.

That’s a contrast to India, where Raghuram Rajan quickly made his mark after taking over as central bank governor in September, raising rates at his first two policy meetings and outlining ambitious plans to strengthen the economy and financial sector.

A special foreign-exchange swap window that the Reserve Bank of India set up in late August to provide dollars to state-run oil refiners has taken some pressure off the rupee. As of Monday, the swap window had taken in $17.5 billion, boosting the rupee well off its summer lows.

Outside of Asia, Brazil and Turkey also have raised interest rates to tackle inflation and attract investor flows. Brazil additionally launched an aggressive currency intervention program, while Turkey has stepped into the market repeatedly to sell dollars.

South Africa hasn’t taken any special measures, focusing instead on reviving growth. And some worry that elections scheduled for next year in Brazil, India, Indonesia and Turkey may impede more thorough reforms.

“Most of the large EM economies either have reforms that are too small in terms of impact relative to their problems (China and India) or have yet to convince us that they are ready to do what’s needed to address the structural issues they face (Russia, Brazil, South Africa and Indonesia),” Morgan Stanley wrote in a research note.

Yet Asia still has the strongest fundamentals among emerging markets globally, growing substantially faster than Latin America and Eastern Europe, said Endre Pedersen, a fund manager at Manulife Asset Management in Singapore.

What’s more, the summer’s selloff shook out many short-term investors, leaving mostly “real-money” investors who are in it for the long haul. That means that when the Fed does eventually taper, “the reaction should be far more muted on most markets, at least in Asia,” Mr. Pedersen said.

Still, any renewed tapering fears are likely to refocus attention on countries with weak fundamentals, especially those with “twin deficits” in their budgets and current accounts. In Asia, that’s India and Indonesia again.

Mr. Pedersen says China, as a relatively closed economy, should be one of the least impacted by foreign flows. Singapore, with its strong economy, and the Philippines, buffered by large remittance inflows, should also fare well.

“It’s still going to break down into the deficit versus the surplus countries,” said Ashley Perrott, head of pan-Asia fixed income at UBS Global Asset Management.

Not everyone buys that argument. Guy Stear, head of Asia research at Societe Generale, says high foreign ownership and valuations make Indonesia, Thailand and the Philippines most sensitive to a renewed bout of tapering fears; India, he says, will be less vulnerable this time around.

Frederic Neumann, co-head of Asian economic research at HSBC, finds some encouraging signs for the region as a whole. Borrowing costs have come down since the summer but remain higher than at the beginning of the year, meaning they have less room to rise in another selloff. In addition, the summer selloff was magnified by a severe liquidity crunch in China, sparking fears of a hard landing in the region’s economic engine; conditions in China are far calmer now.

Furthermore, the Bank of Japan is continuing to pump large amounts of money into the economy, and the European Central Bank cut interest rates last week and could ease further, helping to keep global markets amply liquid even if the Fed tightens.

At least the initial taper scare showed emerging-market policy makers the consequences of not having their economic houses in order. Whether they heed the warning is another question.

“The eventual tapering on the Fed’s part will, we think, be a net positive for emerging Asia and the emerging world generally,” Singapore Finance Minister Tharman Shanmugaratnam said Wednesday – “as long as we respond properly to this likely outcome: start preparing for it now, have a little more urgency in domestic reforms.”