The rout continues in emerging markets

Investors have continued to flee emerging markets. In the week to 29 January, $6.3bn was pulled out of emerging-market stocks. That’s the biggest such withdrawal since August 2011.

The MSCI Emerging Markets Index has lost almost 7% this year, with some individual markets suffering double-digit declines.

Meanwhile, many emerging-market currencies have been battered, diving against the dollar (see below table for the hardest-hit major currencies). Interest-rate hikes by several central banks did little to stem the tide.

The tide goes out

“After several years of easy money and booming growth, the emerging world is struggling,” says The Economist’s Free Exchange blog. “Countries that have become complacent are being picked off one by one by the markets.”

In the past few years, all the money created by Western central banks has sought juicy returns in emerging markets. Now money is starting to flow back to the rich world as the US Federal Reserve tapers its money-printing programme.

The tapering process is seen as a prelude to an eventual rise in US interest rates, making risky, emerging-market assets less attractive.

Worst-performing major currencies in 2014This is especially awkward for countries whose economies depend on foreign capital to cover current-account deficits. In other words, they borrow from abroad because they live beyond their means. To keep foreign money in the country the yield on local assets has to rise, which in turn implies higher local interest rates and a squeeze on growth.

In countries where local politicians have rattled investors, or foreign capital has been squandered on blowing up a consumer boom rather than, say, invested in infrastructure – such as Turkey – rates usually have to rise even higher to keep foreigners around.

Rates will have to rise yet further before the sell-off dissipates, says Citigroup. That’s because the returns investors are getting are still too low, adjusted for inflation. India’s ‘real’ interest rate is still negative and South Africa and Indonesia’s barely positive, for instance.

Markets are discriminating

Now that foreign money is harder to come by, many emerging economies are in for a long slog, says Ian Campbell on Breakingviews. Currency weakness and stronger growth in developed countries will buoy exports, but in some cases getting the economy onto a firmer footing could take years, not months. It doesn’t help that China, a key source of demand for commodity producers, has slowed.

The good news is that investors have differentiated between economies that have got their act together and tackled reforms, such a Mexico, and poorly run states such as Argentina. As a result, emerging markets look less vulnerable to a late 1990s-style crisis.

Still, while the fundamentals may not merit a domino-style collapse, “once investors start to sell in order to get ahead of the crowd, they become a crowd”, as Breakingviews’ Edward Hadas puts it.

Two things could trigger this kind of across-the-board panic, reckons Free Exchange. More countries could face social upheaval, making necessary reforms (or even higher interest rates) impossible, thus undermining investor confidence.

A second factor could be “a sense that the emerging economies are fibbing about the state of their financial systems” – after credit booms in several states, banks and companies could be dodgier than they appear.

But so far, at least, it’s not 1997 all over again – and the slide has yielded buying opportunities.

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