The Moment Of Truth

By Maarten-Jan Bakkum, Senior Emerging Market Strategist, ING Investment Management

Speed read: Maarten-Jan Bakkum looks at the growing pressures on emerging markets; he identifies China, Thailand, Turkey, Malaysia and Brazil as the most vulnerable economies.

Given favourable long-term economic growth prospects, investors tend to expect a positive outcome of any new crisis situation in emerging markets. We are seeing this once again. For the first time since 2002, emerging markets are under great pressure. Capital funds are draining away from the emerging world because the American central bank is gradually normalising its monetary policy, but also because macro risks in the emerging economies have grown considerably.

 That leads to weakening currencies, which in turn forces central banks to raise their interest rates. Higher interest rates and a poor investment climate due to failing government policies and social unrest are putting further pressure on the already declining level of growth. 

The growth differential between emerging and developed markets has meanwhile dropped to a mere two percentage points.

This differential has not been this low since 2001. And while the pressure on currencies keeps growing and political risks and social unrest increase at a rapid pace, a majority of investors appears to assume that market corrections have gone far enough. Institutional investors have started buying again, and various market makers have issued buy recommendations for emerging markets. Their prime argument is the seemingly attractive price.

But what if the unrest continues? What if the pressure on emerging markets persists? These questions are definitely not hypothetical, since only one third of the capital that flowed into emerging market fixed-income funds, since the American Fed started its quantitative easing in November 2008, has flowed out again.

Last year, the countries with high current account deficits were the first to feel the pressure. Countries such as Turkey, India and South Africa were predictable victims since they had the highest financing needs. The attention has gradually expanded to countries with high institutional and political risks, failing economic policies and poor growth prospects. Brazil, Thailand and Hungary are good examples of this.

But until now it has primarily been the combination of serious imbalances, worsening economic policy and lack of reforms that has led to sharp currency drops and market corrections.

In a situation of declining growth and rising interest rates it can be expected that businesses and households run into problems. After ten years of very high borrowing growth nearly everywhere in the emerging world, the vulnerability to a rise in interest rates is high.

For companies that mainly borrowed abroad, the declining exchange rates are a further problem. Growth in the number of bankruptcies will put pressure on banks. In this decisive phase of the crisis it will be important to determine which emerging markets have the most vulnerable banking sector.

A good indicator for this is the increase in debt as a percentage of the gross national product. The countries that we should be concerned about are China, Malaysia, Thailand, Turkey and Brazil.

 

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