Turbulence in emerging markets: crisis or opportunity?

13 November 2018

Emerging markets (EMs) have endured a challenging year-to-date as their stocks, bonds and currencies have tumbled. In June 2018, Argentina agreed a bail-out with the International Monetary Fund (IMF) after unsuccessful attempts to stabilise the peso, which has depreciated by almost 50% against the US dollar during 2018. Two months later, Turkey became mired in a currency crisis as the lira hit a series of all-time lows against the dollar, prompting fears of financial contagion.

The turbulence marks a sharp turnaround from the strong performance of EMs over the past two years, when their stocks rose and many of their currencies appreciated. A broad EM crisis has yet to materialise, but Pakistan followed Argentina’s lead in October 2018 by opening negotiations with the IMF, and a more challenging external financing environment will continue to generate uncertainty. While the vulnerabilities that lie behind the crises in Argentina, Turkey and Pakistan are not present across the entire asset class, EM volatility has increased during the course of the year due to three factors.

Firstly, rising US interest rates have drawn capital away from emerging markets and towards less risky assets, exposing vulnerabilities in emerging economies dependent on capital inflows. EMs with wide current account deficits, including Argentina and Turkey but also Indonesia and South Africa, have experienced sharp currency depreciation. As the US economy is growing robustly, the Federal Reserve is forecasted to raise interest rates on a further four occasions by end-2019. Tighter US monetary policy has also strengthened the dollar, making it more costly for EMs to service hard currency debt.

Secondly, quantitative easing (QE) is giving way to quantitative tightening (QT) as major central banks withdraw the economic stimulus measures introduced after the 2008 financial crisis. QE suppressed bond yields in wealthier economies, causing capital to flow to emerging markets as investors sought better returns; QT will have the reverse effect as liquidity is withdrawn and capital returns to safe havens.

Finally, challenges to the global trade framework pose a downside risk to emerging markets and have undermined the performance of the Chinese yuan, which fell to a 10-year low against the dollar in late October 2018. Trade protectionism has fuelled fears of an economic slowdown in China, but open economies in Southeast Asia are also highly exposed to the rise in trade tensions. Protectionist measures have yet to have a serious impact on China’s economic prospects, but a significant slowdown in Chinese growth would weigh heavily on investor sentiment and capital flows to EMs.

While almost all EMs have grappled with these challenges, the severity of the impact has varied. Argentina and Turkey have borne the brunt of the losses due to a combination of economic imbalances, high external debt, low foreign-exchange reserves and policy mistakes. However, not all EMs are as exposed to a strengthening dollar as some have limited external vulnerabilities. EMs have made progress in a number of areas as the foreign exchange reserves of Brazil, India, Indonesia and South Africa have risen over the past ten years, while EM current account balances have broadly improved since the 2013 ‘Taper Tantrum’, a short-lived EM sell-off prompted by the US’s announcement that it would wind down its QE programme.

However, a major escalation in trade disputes or a faster-than-expected rise in the US dollar and Federal Reserve rates pose broad downside risks, and country-specific challenges remain. The risk of policy instability will remain high in India and Indonesia ahead of upcoming elections in 2019, while Brazil’s new president faces a number of economic and political challenges following a highly polarising election. Across EMs, rising populism amid a less favourable external financing environment poses challenges for investors.

The Institute of International Finance estimates that with the exception of China, which is set to benefit from a rise in portfolio investment, non-resident capital flows to EMs will fall by 30% in 2018 to around USD 560 billion and remain at a similar level in 2019.

Turbulence in emerging markets: crisis or opportunity?

The decline in global liquidity will therefore increase the risk of financial shocks as market tolerance for vulnerabilities in EMs is reduced. In this Risk Focus, we assess the risks in Argentina, Brazil, China, India, South Africa and Turkey, which have all experienced significant currency depreciation but illustrate different degrees of vulnerability.

With greater volatility there is always significant business opportunity: EMs remain growth outperformers as their real GDP is forecasted to expand by 4.9% in 2018, over twice as fast as developed markets. Our Credit, Political & Security (CPS) team can help investors to take advantage of the opportunities presented by EM growth. We support investors by arranging insurance contracts that indemnify loss arising from political risk, non-payment/performance risk, political violence risks, kidnap & ransom and contingency risks. The CPS team advise upon risk and structure solutions that enable trade and investment, mobilise finance and secure people and assets, realising opportunity in volatility.

Turbulence in emerging markets: crisis or opportunity?

ARGENTINA

Argentina has been at the forefront of investor concerns about EM risk, as it continues to suffer from elevated inflation rates and a large current account deficit. Throughout 2018, Argentina has experienced currency sell-offs and financial volatility, amid weak investor sentiment.

A bailout agreed with the International Monetary Fund in June 2018 initially stabilised the peso. However, the central bank’s decision to raise interest rates to 60% at the end of August 2018 failed to halt the slide of the peso, which has lost almost 50% of its value this year.

Sovereign credit risks will remain elevated as nearly 70% of total government debt is foreign-currency denominated. Argentina’s central bank estimates that foreign exchange reserves have fallen from around USD 64 billion in January 2018 to just under USD 50 billion in September 2018. Argentina’s economy is likely to remain in recession until at least the beginning of 2019, with real GDP growth forecasted to contract by 1.3% in 2018.

In response to the crisis, Macri’s government presented stricter austerity targets to Congress in September 2018 and reintroduced taxes on all exports, marking a climb-down from a ‘gradualist’ approach to economic reform. However, opportunities will remain in Argentinian agribusiness, as a weaker peso enhances competitiveness and deteriorating trade relations between the US and China benefits Argentina’s soybean exporters.

BRAZIL

While the real has fallen by 11% against the US dollar in the year-to-date, Brazil’s exposure to currency pressures is mitigated by a low share of foreign currency-denominated debt and robust foreign-exchange reserves. Instead, the main challenge concerns the primary fiscal deficit, which is expected to rise sharply from USD 18 billion in the second half of 2017 to USD 33 billion in the same period of 2018. General government debt has also increased rapidly from 70.0% of GDP in 2016 to a forecasted 77.5% in 2018.

Far-right congressman and former army captain Jair Bolsonaro was elected president in October 2018 and will take office in January 2019. Bolsonaro’s economic adviser, Paulo Guedes, is likely to pursue market-friendly measures including pension reform and the privatisation of state-owned firms, which could attract significant foreign investment.

Following his victory, Bolsonaro affirmed his commitment to tackling the country’s budget deficit. However, 30 parties are represented in the lower house of Congress and 21 in the Senate. The highly fragmented nature of Congress will complicate attempts at implementing reforms. In addition, tensions may arise between Guedes and Bolsonaro, who as a congressman voted against a number of pro-market reforms.

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CHINA

Real GDP growth is forecasted to fall slightly to 6.7% in 2018 and 6.1% in 2019 as China deleverages and trade protectionism weighs on sentiment. Credit growth to the real economy has declined by an annual rate of 4 percentage points since July 2017 as the government seeks to curb the country’s high levels of debt.

Elevated levels of Chinese corporate debt continue to pose counterparty risks and around 10% of SOEs are estimated to be very highly leveraged, elevating contingent liability risks. However, China’s foreign-exchange reserves are the largest in the world and the country’s debt is primarily denominated in local currency.

The greater risk is therefore of an economic slowdown, which would also weigh heavily on investor sentiment towards EMs. Trade tensions continue to rise after the US imposed tariffs on USD 200 billion of Chinese imports in September 2018. The tariff rate is expected to rise to 25% in 2019, which will weigh on economic growth more substantially.

After China posted economic growth of 6.5% in the third quarter of 2018, the slowest pace since the 2008 financial crisis, there is an increasing likelihood that deleveraging measures will be scaled back. However, a further rise in debt would elevate the risk of financial instability and increase medium-term economic headwinds. Despite these risks, China is broadly moving away from an investment-led growth model, with private consumption set to rise from 39.7% of the economy in 2017 to 45.2% in 2027. As a result, China offers significant opportunities for international firms able to tap into its large and rapidly expanding consumer market.

INDIA

The Indian economy will be an outperformer among EMs, as Prime Minister Narendra Modi pursues a growth-positive reform agenda. Priorities will include improved tax collection and the formalisation of economic activity. The economy has now largely recovered from the impact caused by demonetisation and the introduction of a Goods and Services Tax (GST) in 2016/17. In Q1 FY2018/19 growth reached 8.2% y-o-y, while real GDP growth in FY2018/19 is forecasted at 7.3%.

This robust outlook will be driven by a strong performance in the manufacturing sector, amid export growth and private consumption. The government’s ‘Made in India’ campaign is also attracting foreign investment in the manufacturing sector. For example, in July 2018 Samsung Electronics opened the world’s largest smartphone manufacturing plant in Uttar Pradesh.

Despite India’s positive outlook, downside risks remain. The rupee depreciated by 11% against the US dollar between January and September 2018, amid the global EM currency sell-off. This will heighten the impact of rising oil prices on the manufacturing sector, while also driving inflationary pressures in the coming quarters.

Consumer price inflation is forecasted at 5.3% by the end of 2018. There are also rising credit risks in the Indian economy, given high levels of non-performing assets in public sector banks, which hold approximately 75% of total deposits. Non-performing loans in Indian banks rose from 2.9% of gross loans in 2012 to 11.8% in June 2018. General government debt is also elevated at 69% of GDP in the fiscal year ending in March 2018, while interest payments equate to around 22% of general government revenue.

SOUTH AFRICA

Expectations that President Cyril Ramaphosa would introduce economic reform and enhance the operating environment have faded since his inauguration in February 2018, and South Africa’s economic weaknesses are facing renewed scrutiny by investors. Elevated unemployment and strengthening inflationary pressures will continue to limit consumer demand and the performance of the manufacturing sector.

The economic outlook will remain challenging as the administration lacks the fiscal and monetary space to introduce growth stimulus. Real GDP growth is forecasted at just 0.7% for 2018. A stimulus and recovery plan announced in September 2018 saw the reprioritisation of USD 3.5 billion in spending. However, the impact is likely to be limited, given that the package equates to just 1% of GDP.

There will also be significant uncertainty in the operating environment as general elections approach in 2019. Ramaphosa will have to balance the need to maintain investor confidence alongside growing pressure for populist policies to appease voters, particularly amid the political challenge posed by the left-leaning Economic Freedom Fighters (EFF) party.

The ruling African National Congress’s plans to amend the constitution to allow land expropriation without compensation demonstrates the growing risk of populist measures.

Turbulence in emerging markets: crisis or opportunity?

TURKEY

President Recep Tayyip Erdoğan’s pursuit of unorthodox monetary policy has eroded investor confidence in Turkey’s highly leveraged economy. The US decision to double tariffs on Turkish metals in August 2018 triggered a sharp and sustained sell-off of the lira, which has lost over 30% of its value against the dollar in the year-to-date.

While government debt-to-GDP is modest, Turkey is particularly vulnerable to a withdrawal of global liquidity due to its large current account deficit, low foreign-exchange reserves and elevated levels of foreign currency-denominated debt. Real GDP growth is forecasted to fall to 3.8% in 2018 and 1.2% in 2019.

The lira’s sharp depreciation will lead to a growing number of corporate defaults, particularly in the energy, real estate and construction sectors, as firms face difficulties in meeting external debt obligations. Turkey unveiled its New Economy Program (NEP) in September 2018, which seeks to rebalance the economy by tackling the current account deficit and introducing more realistic growth targets. However, significant risks remain over its implementation. While Turkey has belatedly raised interest rates, policy credibility is still lacking and inflation reached 24.5% in September 2018. As a result, Turkey will remain vulnerable to macroeconomic shocks and the implementation of quasi capital controls cannot be ruled out. On a more positive note, a weaker lira will boost exports and help to narrow the current account deficit.

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For further information, please contact Eleanor Smith, Senior Political Risk Analyst on +44 (0)121 626 7837 or email eleanor_smith@jltgroup.com.