Tag Archives: India

The Weekly Mishmash: December 5

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1. And the currency that matters most to EM investors is…
Vivianne Rodrigues, FT Beyond Brics

The fate of the eurozone topped EM investors’ worries at a recent conference. The investors put much higher odds on a eurozone breakup vs. a hard landing in China. Panellists expect Central Europe to be the biggest EM casualty of the euro turmoil. But not all was gloom and doom as a number spoke bullishly about EM corporate debt.

EM Muser: The CEE region is directly in the line of fire of eurozone turmoil given their strong trade and financial linkages. As I noted in a recent post, the banking sector is a particular worrisome source of contagion as Western European parent banks dominate lending in the CEE region via local subsidiaries. Signs of a credit squeeze are already apparent. (See: Is CEE Better Prepared This Time Around?)

As for EM corporate debt, it’s a growing asset class with high yields and many of the issuers are investment grade. However, caution is warranted. According to Fitch Ratings, issuers in Russia and Turkey could face financing problems in a prolonged global downturn given their limited cash cushions. (See: Bloomberg article)

2. India: Fiscal challenges are opportunities
DBS Group Research

The eurozone crisis and global slowdown have come at a bad time for India. The budget deficit has widened relative to 2008, leaving the government with limited room to use fiscal policy to support growth. DBS believes markets have not priced in these fiscal risks. The government has targeted a budget deficit of 4.6% of GDP for FY2011/12, but DBS says it could be as high as 8.5% of GDP.

EM Muser: India’s public debt load has declined in recent years and is below that in most advanced economies. However, at roughly 70% of GDP, it’s still high compared to other EMs – a point I highlighted in a post a while back. (See: Emerging Markets: Fiscal Health Check) 

If the government posts high deficits, it will add to the debt load and could end up weighing on growth and threatening the country’s sovereign credit rating. According to Moody’s, the public debt burden is a major stumbling block that has prevented India from securing an investment-grade rating from the agency.

3. Presentation: Sub-Saharan Africa Outlook
Marion Mühlberger, Deutsche Bank

This presentation provides an upbeat view of Sub-Saharan Africa’s economic prospects and notes the region’s low public debt levels and improved macroeconomic policies.

While Europe remains the region’s most important trading partner, economic ties have grown with Asia, making it the second most important market. The region is very commodity-oriented, but it varies by country. For example, Angola and Nigeria are very oil dependent (90% of more of total exports), while gold is Ghana and Tanzania’s main export.  The presentation does warn investors not to be complacent about political risk.

EM Muser: DB’s hopeful growth outlook for Sub-Saharan Africa is shared by the IMF, in its latest Regional Economic Outlook in October and by the Economist magazine. The cover of the December 2nd issue is titled, ‘Africa Rising.’

Nigeria exemplifies the many risks and opportunities in the region. The democratic election of Goodluck Jonathan in the presidential race earlier this year marked a turning point as it was widely hailed as free and fair. Moreover, the country boasts a large, young population (around 154 million), significant oil  (OPEC’s 6th largest producer) and the region’s second largest stock market behind South Africa. However, many challenges remain – from violence in the north to regional tensions to infrastructure decay – so investors need a strong stomach.

4. 2011 Corruption Perceptions Index
Transparency International

TI released the results of its 2011 Corruption Perceptions Index, covering 183 countries, on December 1st. The usual suspects – i.e. the Nordics – dominated the top 10. Not surprisingly, Somalia and North Korea came in at the bottom of the rankings.

Source: Transparency International

EM Muser: I created the chart above to highlight the scores of a select number of EMs over the last 3 years. If you’re interested in the score of a country not listed, click through to the TI report for the full results. Among the grouping, Russia continues to be perceived as the most corrupt, with Chile the least corrupt.

I find the underlying trends to be as interesting as the rankings themselves. For example, perceived corruption has noticeably improved in Poland over the past three years, while it has steadily worsened in Hungary, South Africa, Colombia and Mexico.

Which Emerging Markets Appear Vulnerable? A Look at Early Warning Indicators

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All eyes are now on the eurozone debt crisis. However, we know from past experience that problems in advanced economies can spill over to the rest of the world with dangerous consequences. Emerging markets are not immune. The IMF Director Paulo Nogueira Batista Jr recently expressed concern that capital could flee Brazil if the eurozone debt crisis intensifies, and his concern is not unfounded.

As seen in 2008-09, global risk appetite dried up and prompted large capital outflows out of many emerging markets, particularly in Eastern Europe. As a result, certain economies found themselves teetering on the edge of crisis. Latvia, Hungary and Romania were among those who turned to the IMF for help.

These Eastern European economies showed vulnerabilities before the onset of the global financial crisis, as exhibited by high current account deficits and heavy external debt service obligations. However, it took an external shock to bring these vulnerabilities into the spotlight.

So which EM economies look vulnerable in the event of another sudden stop in capital flows?

Below I look at a cross-section of emerging markets and compare their relative vulnerability to a sharp slowdown in capital inflows. (Note: the set of EMs was chosen largely based on data availability).

There is no defined set of early warning indicators that perfectly predicts which countries are at risk of a crisis, but some have stronger predictive power than others. Jeffrey Frankel and George Saravelos conducted a sweeping literature review to find the most consistent leading indicators of crisis. (See: Reserves and other early warning indicators work in crisis after all)

Measures of international reserves and the real exchange rate stand out as the best tools to assess a country’s vulnerability. Their findings suggest the current account balance is also a good indicator to monitor.

Figure 1: Adequacy of international reserves

Source: IMF, national central banks, author’s calculations

*Stock of external debt as of June 2011, **GDP based on IMF’s latest 2011 forecast

International reserves provide a certain degree of insurance against capital flow volatility. Among the EMs surveyed, Russia and India stand out for their relatively large caches of international reserves, while Turkey ranks near the bottom of the pack, both as a % of external debt and % of GDP, which is a source of vulnerability. Blogger Emre Deliveli, as well as journalist Taylan Bilgic, questioned the adequacy of Turkey’s reserves in a recent column.

The ratio of short-term debt to reserves is a particularly good measure for assessing vulnerability. The lower the ratio, the better. Unfortunately, not all countries provide data on short-term debt, but a few do. For example, India’s ratio is 21%, well below Turkey’s ratio of roughly 86%.

This measure, like the others, needs to be taken with a grain of salt. A country may have a large chunk of debt coming due within the next year, but may have very strong macro fundamentals, making repayment problems highly unlikely. So it’s always necessary to consider the context. In any case, Turkey also looks vulnerable on this measure.

Figure 2: Divergence of Real Effective Exchange Rate from Trend

Source: BIS, author’s calculations

The probability of a currency crisis increases when the real exchange rate is overvalued relative to trend. However, this needs to be taken with a grain of salt as well. For example, many Asian currencies showed no significant appreciation in the late 1990s, yet these economies still descended into crisis.

On this measure, the Brazilian real and Indonesian rupiah currently show the most overvaluation relative to trend. In contrast, Turkey looks to be the least vulnerable on this measure.

Figure 3: Current account balance

Source: IMF WEO Database, September 2011

Large current account deficits also increase the probability of crisis and indicate that a country is borrowing more than it’s saving. All recent financial crises (eg. the Asian Crisis, Argentina in 2000, Brazil in 2002) featured current account deficits, with the exception of Russia in 1997. A current account deficit is not necessarily a bad thing if it is financing activities that are enhancing the country’s productive capacity. However, a deficit can quickly become unsustainable if a country is unable to secure the necessary external financing to fund it.

On this measure, Turkey – and to a lesser degree, Poland – look potentially vulnerable.

Conclusion

A look at early warning indicators suggests that Turkey is vulnerable to a sudden stop in capital flows based on its relatively low level of reserves and high current account deficit. Poland also looks vulnerable – albeit less so than Turkey. However, as I note above, these measures need to be taken with a hefty grain of salt. They’re useful in figuring out where a countries’ vulnerabilities may lie, but further investigation is necessary to understand the context.

EM Currencies: Same Same But Different*

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Investors fled out of EM currencies at the height of the global financial crisis and retreated into safe haven currencies, such as the Swiss franc and Japanese yen. The recent market turmoil triggered a similar pattern, as EM currencies continue to be risk-sensitive. But there’s now greater variation. Certain EM currencies have shown considerable resilience and I expect greater differentiation among EM FX going forward.

Flight to Safety – Where’s That?

The VIX index – which measures the implied volatility of the S&P 500 and is used as a proxy for risk sentiment – rose to its highest level in over two years on August 8 and remains elevated. In reaction to this spike in risk aversion, most EM currencies slipped against the US dollar, as seen in Figure 1 below.

Figure 1: Most EM currencies weakened against the USD in early August when risk aversion spiked

Source: Oanda, author’s calculations

Investors’ gut reaction in times of market stress is to retreat from emerging market currencies. However, there are signs of gradual change. Some – such as the Chilean peso, Czech koruna and Indonesian rupiah – showed considerable resilience in early August, in contrast to their sharp weakening at the height of the global financial crisis. (See Figures 2, 3 and 4 below.) Financial commentator Martin Hutchinson recently went so far as to call the Chilean peso a ‘safe haven’ currency.

Figure 2: Select South American Currencies in Comparison

Source: Oanda, author’s calculations

The Brazilian real and Chilean peso have steadily strengthened against the US dollar since the height of the global financial crisis, albeit to a lesser degree than the Swiss franc, a major safe haven. When the S&P 500 plunged in early August, the Chilean peso held relatively steady, while the Brazilian real weakened, though it so far has not plunged like it did in late 2008-early 2009.

Figure 3: Central European Currencies in Comparison

Source: Oanda, author’s calculations

The Czech koruna, Hungarian forint and Polish zloty are all highly correlated with the euro, which is not surprising given these economies’ strong ties to the eurozone. As a result, these currencies are vulnerable to an intensification of the eurozone crisis.

Meanwhile, high levels of Swiss franc borrowing among Hungarian households’ [See related post: Hungary Mortgage Relief: Another Move to Delay the Pain) and moderate levels of franc borrowing among Polish households are also weighing on these currencies. As the Swiss franc has surged (given its safe haven status), there are concerns that it could slow economic growth and potentially even threaten financial stability. Notably, the Czech Republic – which has scant levels of fx-denominated borrowing and a lower public debt burden relative to the rest of Central Europe – has seen its currency diverge from the other two since mid-2010.

Figure 4: Select Asian Currencies in Comparison

Source: Oanda, author’s calculations

The Indonesian rupiah and Philippine peso showed considerable resilience against the USD, relative to other EM currencies, at the beginning of August. Authorities in both these countries have traditionally not shied away from intervening to smooth out volatility. In fact, Indonesia’s central bank recently said it plans to support the currency by purchasing IDR-denominated government bonds if there’s a large sell-off. As for India, the rupee dipped considerably against the USD in early August. India’s high current account deficit and large public debt burden make the INR more vulnerable to sell-offs in times of market stress.

Structural Change Afoot

Problems in advanced economies look to be more structural than cyclical, suggesting they’re not going to be resolved anytime soon. The US lost its prized triple-A rating from S&P on August 5 – the first downgrade in the country’s history. Meanwhile, the eurozone crisis continues to gather momentum, with Italy and now France coming into the spotlight. The broad political consensus needed to tackle these issues is lacking.

We’re moving toward a more multipolar world where the economic clout of emerging markets will grow ever larger, as Lupin Rahman of PIMCO describes. I also touched on this gradual structural shift in my post: Can Emerging Markets Replace the US as the World’s Consumer of Last Resort?.

The bottom line is that emerging markets are not immune to ripple effects from problems in the US and eurozone given their strong trade and financial ties. Nevertheless, their longer-term prospects are generally brighter than those in the developed world (with certain exceptions) given their lower debt burdens, more favourable demographics and faster economic growth.  (See related posts: The Double Whammy: Debt and Demographics and Emerging Markets: Fiscal Health Check)

As a result, I expect old patterns – where investors automatically flee away from all EM assets in times of trouble – to gradually change. Signs of that shift are already apparent, as noted above.

*See Wikipedia for explanation of title phrase ‘same same but different.’