Minimising currency risk is key to finding EM bargains; Risk is that everyone seeks to devalue in response to outflows

February 18, 2014 8:18 am

Minimising currency risk is key to finding EM bargains

By John Plender

Risk is that everyone seeks to devalue in response to outflows

Is the emerging-market scare already a thing of the past? Certainly the level of redemptions has abated from emerging-markets equity funds that are tracked by data provider EPFR Global.

Last week investors redeemed $3bn, halving the $6bn in the previous two weeks, while some markets even saw capital inflows. More importantly, the past month has not produced anything equivalent to the near-collapse of the Long-Term Capital Management hedge fund that followed Russia’s default in the earlier emerging-market panic of 1998.

The implication is that the vulnerabilities in emerging markets have lessened with time. Bank lending to the developing world is less concentrated than in the 1980s and 1990s. Capital inflows have been more stable, increasingly in the form of foreign direct investment and portfolio capital rather than short-term bank finance. There has been less borrowing in foreign currencies and a bigger cushion of foreign exchange reserves, which means that currencies have been able to take much of the strain where countries are heavily dependent on external finance.

At the same time the US Federal Reserve’s rebuttal ofcalls for international co-operation from emerging markets suggests a lack of concern about financial contagion in the developed world, in contrast to the position in the late 1990s when the Fed felt compelled to act to boost economic growth.

There is nonetheless a risk that the impact on the rest of the world is being underestimated. There is no question that emerging-market economies are heading for lower growth, which will hit the developed world through reduced import demand.

In the case of China it is a structural slowdown accompanied by a worrying build-up of private sector debt, which may not result in a financial crisis now, but suggests potential trouble in future. And there are also pockets of exposure in the developed world banking system, notably in Europe where emerging markets loom uncomfortably large in relation to some banks’ capital.

Currency mismatches

Because these countries are now a much larger chunk of the global economy than in the 1990s, the potential spillover effects in the developed world are that much greater, with Germany and Japan looking the most vulnerable of the larger economies to reduced exports. Emerging-market economies have also become more interdependent, especially in Asia where many countries are increasingly reliant on their neighbours for export income. Loss of that demand will exacerbate the impact of the slowdown.

Nor have currency mismatches gone away. They have simply shifted from the public to the corporate sector. According to Philip Turner of the Bank for International Settlements, the emerging-market corporate sector is now a repository of potential systemic risk because companies have been engaging in a carry trade. Through their overseas subsidiaries, they have been borrowing at the exceptionally low rates engineered by central bankers in the developed world to invest in domestic assets.

From 2010 to mid-2013 emerging-market borrowers raised about $990bn on international bond markets, of which $700bn was taken by the non-bank corporate sector. This could spell balance sheet trouble for borrowers as currencies tumble, which in turn would pose a threat to banking systems. The familiar pattern of bank lenders sustaining hits to their balance sheets, forced deleveraging, credit contraction and negative wealth effects would re-emerge

If governments are then obliged to bail out banks, public-sector debt will rise again, potentially setting in train a vicious circle whereby tighter fiscal policy would have to be adopted. The result would be weaker domestic demand, more balance sheet pressure and more financial stress.

No rush to ‘fragile five’

All of this is “in the market”. So should investors plunge in to take advantage of the widening valuation gap between the developed and developing world? No doubt there are opportunities to be had, but there has been no Gadarene rush to embrace the fragile five: Turkey, South Africa, India, Indonesia and Brazil. Nor does such a rush look likely in the short term. This is partly because of currency risk. Investing in them amounts to a bet on emerging-market policy makers declining to engage in competitive devaluation.

The lack of appeal in that bet was illustrated last week by Kazakhstan’s devaluation, which was precipitated by the pressure arising from the plunge of the Russian rouble to a record low. That followed Argentina’s devaluation last month. The risk is that everyone seeks to devalue in a sauve qui peut response to capital outflows and balance sheet pressures.

In such a climate speculators can be relied on to attack countries with weak reserve positions and a reluctance to raise interest rates. So many of the emerging-market economies with the greatest recovery potential will be among the most dangerous for investors. Minimising currency risk will be the key to investors making the best of the continuing catch-up potential of the developing world.