Emerging markets take a tumble

Last week, the currencies of several developing countries plunged, hitting stock markets around the world. Is more trouble brewing? Matthew Partridge investigates.

Why the slump?

At the end of last week, several emerging-market currencies and stock markets slid sharply. Argentina saw the value of the peso plunge as its central bank – albeit briefly – gave up intervening in markets to defend the currency.

The Turkish lira slid amid political turmoil over a corruption scandal, forcing a drastic hike in interest rates by its central bank. China’s wobbly economic growth and more riots in Ukraine also unnerved investors.

However, despite there being any number of local issues you could point to as being triggers for the slide, the reality is that crises in emerging markets “are almost invariably triggered by the actions of investors or central banks in the developed world”, notes John Authers in the FT. And this one is no exception.

How so?

The conditions for this slide in markets have been building for some time. Last May, the Federal Reserve warned that it would stop printing quite as much money (the ‘taper’). As Jonathan Allum of SMBC Nikko notes, since Ben Bernanke “mentioned the dreaded ‘t’ word”, emerging markets have been struggling.

The Fed’s quantitative easing (QE) has encouraged developed-market investors to take more risk and invest more heavily in exotic markets, as it maintained interest rates at record lows and ensured plenty of liquidity.

This influx of money makes it easier for companies and consumers to borrow, which can boost growth, but also fuel “bubbles and distortions”, says Allister Heath in City AM.

With US monetary policy now threatening to tighten, this ‘hot money’ is rushing back out, and any country too dependent on it risks seeing its currency collapse or its borrowing costs soar.

Which markets are most vulnerable?

Research group Capital Economics splits emerging economies into five main groups, four of which it considers to be in varying degrees of trouble. The stability of countries such as Argentina, Ukraine and Venezuela is at risk due to “serial mismanagement by the authorities”.

Capital Economics also thinks Turkey, South Africa, and many southeast Asian and Latin American countries have “lived beyond their means” and “now face a period of weaker growth”. Emerging Europe is “fragile” due to “the legacy of previous booms” and “strong financial ties to the eurozone”.

Brazil, Russia, India and China (the Brics) also face “domestic structural problems”, though the outcome here depends on “economic reform rather than events in Europe or the actions of the Fed”.

The bright spots are economies such as South Korea, the Philippines and Mexico, where economic reform and strong exports are helping to maintain growth.

Should we be worried?

Hugh Hendry of hedge-fund group Eclectica believes that, although markets will remain vulnerable to these sorts of scares, monetary policy will remain loose. With developed-world banks still fragile and unwilling to lend, global growth simply won’t be strong enough to fuel a sustained recovery.

Japan, America and China will end up competing with one another via monetary policy to boost domestic growth by having the weakest currency. “Stronger growth in one part of the world on the back of easier policy will be countered by even looser policy elsewhere.”

With these “currency wars” ongoing, “market expectations of tighter policy will always be rescinded and emerging markets will recover rather than crash”. It’s also worth noting that previous emerging-market crises haven’t necessarily fazed developed markets.

The 1997 Asian crisis was devastating for the nations involved (see below),but it had little impact on the S&P 500. As Ed Yardeni of Yardeni Research points out on his blog, in 1997 the US market rose by 31%, with just one brief correction of 9.6%. Even in 1998, which saw a bigger correction and the Russian ruble crisis, the S&P 500 gained 26.7%.

Are there any buying opportunities?

As Authers notes in the FT, investors are withdrawing their money from ‘good’ and ‘bad’ markets alike. He suggests “this will create anomalies that can be exploited”. Exporters in particular – as opposed to the consumer-goods stocks that most investors have been focusing on in recent years – should do well from weaker currencies.

Capital Economics points out that countries undergoing genuine reform, such as Mexico and South Korea, are also worth considering. We’d also suggest that the cheapest of the Brics – Russia and China – are worth putting at least some money into.

There may be more jitters to come, but on a long-term basis both markets are pricing in a lot of future pain.

The crisis last time – and how it played out

In the 1990s, many Asian nations opened up their economies to foreign investment, which flooded in. But corruption and poor regulation meant banks made lots of bad loans and many became overextended.

In the short run, the credit boom boosted growth. But when the Federal Reserve started to raise interest rates in the mid-1990s, investors started to pull out.

In July 1997, the Thai baht collapsed and panic spread to other Asian economies, even relatively well-run ones, such as Hong Kong. Currencies plunged in a domino effect, while banks, firms and even individuals found themselves unable to repay foreign currency loans, hitting growth.

The International Monetary Fund offered support, but with stringent conditions to do with financial and economic reform attached.

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