Friday 15/02/2019

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When EM sneezes, will the world catch a cold?

The last months have been rough for EM. Since the beginning of the year, the MSCI EM index is down 12% in dollar terms. The MSCI Turkey index trades 55% lower. Among currencies, we note that since the start of  the year, broad BRL trades 13% lower, broad ZAR trades 16% lower, broad TRY has fallen 40% and broad ARS trades more than 48% lower. Even without mentioning the extreme case of Venezuela, we can conclude that the losses are substantial. Looking across the EM universe, it seems that more is going on than problems in Argentina and Turkey, which have been struggling with external financing needs for a while now. Today, it appears that contagion is spreading.

What’s more, the troubles in EM are starting to weigh on DM. Of course, there are numerous reasons for the entire EM universe to enter troubled waters. The prospect of tighter global monetary conditions on the back of the Fed moving rates higher is a common concern. Another central theme is the deceleration of Chinese growth. In addition, the emerging world is dealing with a strong USD, uncertainties with regard to protectionism and pressure on commodity markets. How big is the risk of contagion from Argentina and Turkey to EM and the rest of the world really? When EM sneezes, will the world catch a cold? This blogpost takes a closer look at the risk of EM contagion using some of the most pronounced cases of EM contagion during the last decades.

Consider the Mexican peso crisis of 1994. The crisis was a result of monetary and fiscal policies that were unsustainable given the fixed-exchange rate Mexico maintained versus the USD. Mexico was forced to implement a devaluation. Markets were surprised by the decision and reacted strongly. The panic reached other countries in the emerging world, especially in Latin-America. Only a few years later, Thailand’s position started to look shaky after a period of explosive credit growth of lending in the property sector, mainly financed by borrowing from foreign financial institutions. The bankruptcy of Thai financial institutions and speculative attacks against the currency forced Thailand to let the currency float. The Asian Financial Crisis of 1997 spread to countries with an economic structure similar to Thailand. Malaysia, Indonesia and the Philippines were next. Other regional currencies suffered from subsequent speculative attacks. The financial crisis pushed the East Asian region into recession with spillovers across the rest of the world, including DM. Especially Japan was hurt, as its economy was still fragile after a long period of meagre growth. At first glance the Great Financial Crisis of 2008 originated in DM, but EM played an important role in the build-up to the crisis worth mentioning. In the aftermath of the crises of the late 90’s many EM  took advantage of relatively good global economic conditions to strengthen their economic and financial fundamentals. Many implemented the use of flexible exchange rates, build up ample reserve buffers and created multiple financial safety nets. However, by increasing their reserves, EM stimulated the global demand for safe-assets, putting significant pressure on US rates. This pressure intensified the search for yield, including the demand for higher-yielding structured products that turned out to have disastrous consequences for the global financial system. When the financial crisis hit, followed by the Great Recession, many EM joined the global downturn. This experience demonstrated the increased integration of EM in the world economy. Another important episode is the taper tantrum of 2013, when Ben Bernanke‘s comments about tapering asset purchases drove US rates higher and sparked a broad sell-off in EM assets. However, during subsequent bouts of volatility there was much more market differentiation: investors focused particularly on countries with larger external financing needs. At the time, these problematic countries were Brazil, India, Indonesia, Turkey, and South Africa, a country group called the Fragile Five.

We can draw three important conclusions. First, today’s sell-off is significant although nowhere near past crises. Therefore, valuation in EM has become more attractive. This being said, the challenging backdrop of tighter monetary conditions, the risk of protectionism and a looming Chinese growth slowdown will not change overnight. This means that EM are not out of the woods yet. Second, EM are at the core of the world economy. When EM sneezes, the world catches a cold. Considering the ever closer integration of EM with the rest of the world and the size of today’s EM, this is more the case than ever. Third, past crises in EM have demonstrated that when a particular economy gets hit by a shock, there is always a risk of contagion to other EM. This happened in Mexico in 1994 and in Thailand in 1997. What’s more, market expectations can create self-fulfilling crises, as clearly demonstrated during the series of speculative attacks during the Asian Financial Crisis in the late 90’s. However, the aftermath of the taper tantrum of 2013 demonstrated that increased market differentiation in EM can also occur when the dust settles. This is an important reminder for today’s events: not all EM are in the same boat and considering the diverse nature of the EM universe, this shouldn’t come as a surprise.