The emerging markets universe has had a very poor month.
The US Fed tapering question, and a ratcheting down of growth expectations for many key emerging economies, both contributed to the rapid sentiment shift.
Investors in the core advanced economies have re-weighted their portfolios away from assets with higher risk profiles and back towards the US dollar and the higher yields now on offer there, fleeing local currency bond and equity markets in the emerging world, driving exchange rates sharply lower.
We aim to do three things here:
– The first is to review recent developments in emerging market capital flows;
– The second is to consider the impact on financial conditions inside emerging economies in the wake of this abrupt change;
– And the third is to outline how we see the situation unfolding over the remainder of this year and into next.
In terms of where we presently sit, exchange rates are the best real time indicator of capital flows, complete data on which tend to arrive with considerable lags. With only a couple of exceptions (China, a few eastern Europeans) emerging market currencies have fallen heavily in the June quarter, ranging from modest moves around -2 per cent (for example, Indonesian rupiah, Polish złoty), medium scale moves around -5 per cent (e.g. Philippine peso, Russian ruble, Thai baht) and those close to or above double digit declines (for example, Indian rupee, South African rand, Brasilian real).
To stylise somewhat, commodity exporters and current account deficit economies have fared the worst, while manufacturing exporters and surplus economies have fared better, although there are exceptions in each of these cases. That makes a great deal of sense. In our commentary on the the Australian dollar over the last month or so (another casualty of the present climate), its external deficit and its China linkage via commodity prices both featured heavily. Similar drivers are clearly at play in the emerging market (EM) space. Higher yielding EM currencies with exchange arrangements that allow good portfolio access (and egress), particularly with regards to local currency fixed income markets, did very well in the quantitative easing sponsored ‘risk-on’ moment.
The flipside of this earlier 'success' was a large foreign capital overhang, and a heightened susceptibility to outflows when US bond yields began to move higher. In emerging Asia, where real economy developments are of keen interest to Australian observers, the weakness of the Indonesian rupiah in the second quarter is clearly understandable.
There are four emerging Asian economies where foreign bond holdings are well documented. They are South Korea (17 per cent), Malaysia (31 per cent), Indonesia (30 per cent) and Thailand (6 per cent). Of these four, only Indonesia presently runs a current account deficit, and it is also the most resource export dependent. That, and the fact that it entered this re-pricing of global yield with a very high exposure to foreign bond investors, and it is no surprise that the rupiah fell sharply.
But wait – the Indian rupee was far from the worst performer in the region. While the South Korean won and the Malaysian ringgit were predictably more resilient, the Philippine peso and the Thai baht both fell significantly more.
Bank Indonesia’s (arguably) defensive rate hike may have calmed nerves among both the foreign and high-net worth communities – or perhaps index managers felt that they should not alter their positions too violently given the recent subsidy reform and the potential for an upgrade to investment grade at some not too distant point.
On Korea, we note that the economy’s current account buffer is quite strong at present, with soggy domestic demand and lower commodity prices trimming the import bill (i.e. as a large resource importer, Korea’s terms of trade have improved) and its competitive export machine having built up a strong market position in recent years while ‘eating Japan’s lunch’ during the strong yen phase. While that era has now passed with the rise of Abenomics, from the perspective of external financial resilience, this particular shock found Korea relatively well prepared.
The Malaysian bond market has arguably been performing a high wire act for some time, with the foreign ownership share quietly rising towards one third. The counterpoint is that its current account surplus is considerable (~6 per cent of GDP) and it has never been a high yielding market in an absolute sense. Here we note that while the Malaysian ringgit looks resilient over the entirety of the quarter, over one month it has fallen more than the average. Notably, the Chinese renminbi was rising in the first two months of the quarter, and that is a very important reference point for the Malaysian ringgit. When the Chinese tremors began to infiltrate investor consciousness, the Malaysian ringgit took a beating. Its leverage to commodity prices may have also played a part.
Just how damaging is a capital withdrawal (or reduced rate of inflow) right at this moment for EM growth as a whole? Thinking about domestic demand principally, we refer to some valuable research by the Washington based Institute of International Finance. Their EM bank credit conditions survey, which tracks lending standards, loan demand, trade finance and bank financing conditions in the major emerging regions, is a good starting point for considering the eventual real economy impact of the current circumstances. Bank credit provision is a vital component of the EM domestic demand cycle. We note that as of the March quarter, just prior to the retrenchment, overall credit conditions in the EM were subdued, with corporate loan demand diminishing and standards tightening a little. External funding conditions for banks, and their willingness to supply trade finance, were both still in accommodative territory but less so than in the previous quarter. It is hardly a huge leap to argue that each of these measures will move adversely in the June quarter, which in turn should mean softer credit growth, and in turn, with a lag, softer economic growth.
Continuing the logic from above, it is those economies with current account deficits that will feel the greatest impact on domestic investment from an external financing shock. The trade finance indicator from this survey is particularly interesting. Extending trade credit basically means sacrificing a portion of your US dollar liquidity. US dollars have become somewhat scarcer inside the EM as a result of the recent shift. Latam was the exception to the ‘less willing’ rule in the first quarter.
Given the weakness of Brasilian real, Chilean peso, Colombian peso, Peruvian neuvo sol and Mexican peso in the second quarter, that will not last. It remains to consider how prolonged the sentiment shift will be. In addition to conducting the credit standards survey, the IIF also forecasts capital flows to the EM. Their updated forecasts, released on June 26 (i.e. with full knowledge of Fed tapering developments) anticipate that net portfolio equity and portfolio debt inflows will decline over the entirety of this year, while the latter is also forecast to decline in 2014.
We are not that pessimistic. Indeed, as we spell out elsewhere in this report, we disagree with the timing and scale of tapering presently factored into US yields and the US dollar, the present distaste for the EM will probably dissipate somewhat later in the year when this development is assimilated into investment decisions. On the other hand, this adjustment will not fully re-instate pre-tapering levels, and nor will real economy developments leave much to get excited about. So from an EM perspective, 2014 won’t be a famine, but it will be a relatively frugal meal, rather than a feast.
Huw McKay is a senior economist at Westpac.