Since the crises that rocked the world’s emerging markets over the late ‘90s, investors fled these markets at breakneck pace. Today, signs of recovery are beginning to appear in some sectors as these economies have begun extensive reforms. Melvyn Westlake looks at which countries are better positioned for a recovery and which are showing signs of stress.
Just when emerging market countries seemed set for a period of strong, stable growth, the outlook has suddenly darkened. Another spell of turbulence threatens. Not only has the global economic climate become less benign, but concerns about individual countries, such as Argentina, have greatly increased.
This is not what the economic forecasters were predicting. Many expected 2000 to be the year that consolidated the emerging markets’ recovery, after the financial crisis that hit so many of them during 1997-99. It was in September that the predictions started to go awry, amid further sharp oil price rises and a slumping euro exchange rate. These market moves were accompanied by another sharp downward spiral in the hi-tech intensive Nasdaq (down 24% in September and October) and the widening of risk spreads on US high yield corporate bonds.
It mostly adds up to bad news for emerging market countries and raises concerns over the outlook for many currencies. Some developing countries, notably in Asia, will be hard hit if the oil price remains at recent levels of $32-34 a barrel. This is $5-6 more than expected last summer when International Monetary Fund economists were preparing bullish forecasts for the following 18 months. On more recent IMF estimates, the world’s extra $200 billion energy bill could knock up to 0.5% off global economic growth, and up to 1% off the expansion of some oil-dependent countries. Not only will energy be more expensive, but some countries will see demand for their exports fall as consumption of non-energy goods drops.
At the same time, the fall in the euro’s value reduces the competitiveness of developing countries, such as Argentina, that sell a sizeable proportion of their exports to Europe. The weakness in US financial markets, meanwhile, suggests that an increasing number of investors now believe that the chances of a so-called “hard landing” for the US economy have significantly increased. That is: the country will experience a recession in 2001 or at least a sharp drop in growth, with a possibly large drop in the dollar.
“The rising oil price and falling US financial asset prices have caused a notable mood shift,” says David Lubin, emerging markets economist at HSBC, in London. Investors have consequently been selling emerging market assets. The risk spreads on bonds have risen 20% during September and October, to 740 basis points (as measured by JP Morgan’s adjusted Emerging Markets Bond Index). This is partly because a US economic hard landing would lead, initially, to higher interest rates ‘ raising the cost of financing for many developing countries ‘ and, subsequently, to lower global demand for exports. That worries investors.
There is also a surprisingly close correlation between Nasdaq and emerging market bond spreads. They are both risky asset classes. “When investors become more risk averse, as now, they sell both,” Lubin says.
Currency specialist Michael Burke, who runs research firm B&M Research, says unequivocally: “Emerging markets, in general, are facing a difficult time over the next six to nine months.”
A key reason is the impact on developing country exports of the slowdown that he sees in the US economy. And this is happening at a time when many emerging market economies, particularly in Asia, have been left structurally weakened by the financial crisis, Burke says.
But it all depends on the extent of the US slowdown. A deceleration in the country’s growth rate from 5-6% to around 3-4% (the rate now predicted for the second half of 2000), would constitute a “soft landing”, says Lewis Alexander, global head of emerging markets research at Salomon Smith Barney, in New York. “We can go from 6% to 3-3.5% without a major dislocation,” he says.
That would place output expansion in the US close to its long-run potential ‘ and can be sustained, in Alexander’s view. This would be the best outcome, because 6% growth is not sustainable anyway. “OK, the international environment is not as benign [for emerging economies] as it was. It is getting worse. But it is not falling off a cliff,” he says.
This more optimistic case does not appear to be shared by a large number of investors. There are some signs that private capital flows to emerging markets in 2000 are not going to be as buoyant as expected. Such flows had been predicted to reach their highest levels since 1997 ‘ before the financial crisis gathered pace in the last quarter of that year. According to the Washington-based Institute for International Finance, a research body for banks, some $188 billion in net private capital flows is destined for the 29 major emerging markets this year ‘ $45 billion up on 1999 ‘ with an even larger, $212 billion flow in 2001.
That is now looking distinctly optimistic. For example, dedicated emerging market equity funds are reporting net redemptions by investors. Equity markets across the emerging world have fared considerably worse than the bond markets, tumbling some 28% so far this year, according to the S&P/IFC composite index. The blame for this, says Jonathan Garner, a senior equity analyst at Credit Suisse First Boston, in London, is a global de-rating of sectors such as the telecommunications, software and electronic component industries. This has influenced these sectors in the emerging markets, which now account for 45-50% of their total market capitalisation. “But I think we are just passing the point of maximum pain. The situation will turn around fairly soon,” says an optimistic Garner.
By comparison with the misery in the equity markets, the 10% total return on emerging market bonds (despite the recent setback), looks quite respectable. It makes these bonds the second best performing asset class in the developed and developing worlds, behind 10-year US Treasury paper.
Unfortunately for emerging markets, even this is now a negative factor. Fearful that conditions are going to worsen in coming months, investors are locking up their profits and withdrawing from the market.
Worse still, when the global economic climate is less supportive, investors tend to focus more critically on the weaknesses of individual countries, says New York-based Arturo Porzecanski, chief economist for emerging markets at ABN Amro. “When everything is going great, investors will overlook weaknesses. They are making money, they want to do deals, they lower their guard, and their risk tolerance increases. But when things are not going so well, they start worrying about everything,” he says.
This is part of the reason why investor anxiety over some individual emerging markets has been rising. In particular, concerns have centred on Argentina, but to a lesser extent on Turkey, Poland, the Philippines, South Africa and Zimbabwe, as well. These countries represent what Claudio Piron, treasury economist at Standard Chartered Bank in London, calls “localised stress points”.
In the case of Argentina, the worries are caused by the lack of output and export growth, despite years of reform, privatisation and de-regulation. The economy has actually been shrinking in some recent months, and is expected to show the lowest overall growth this year ‘ at a mere 0.8% ‘ of any Latin American country. Yet, the country needs the growth to help pay for its huge debts as well as other spending.
On some estimates, Argentina’s financing requirements next year amount to some $19 billion. Much of this will have to come from the international capital markets. And in the present climate of investor “suspicion and ill-will” towards Argentina, that could prove a tall order says ABN Amro’s Porzecanski. Further economic reforms could also be difficult because the governing coalition of President Fernando de la Rua is looking increasing shaky. On top of that, prices for the kinds of agricultural goods exported by Argentina have been dropping for some years, and major trading partners, such as Brazil, have devalued, so making them more competitive.
Above all, the Argentine peso is tied one-to-one to “the strongest currency on earth, [the US dollar],” Porzecanski says. (To eliminate hyperinflation, the peso was fixed permanently against the dollar in the mid-1990s: pesos in circulation must be fully backed by dollar reserves). The country’s options are thus severely limited. One, probably unacceptable, way out is to keep cutting government spending and private consumption. This would lead to a continuous process of deflation and eventually to a political backlash. An alternative is to break the link with the dollar, and devalue the peso. That would “have unimaginable consequences,” says Porzecanski, including the possibility of debt default. More likely, the government would choose to dollarise the whole economy, most currency analysts conclude.
Another stress point in the emerging markets is Turkey, a country that until quite recently was winning accolades for its economic reforms. However, there are growing doubts in the market about whether the country’s exchange rate-based stabilisation programme can succeed. This programme, worked out with the IMF, is very similar to the kind of stabilisation regimes that failed in Mexico in 1994, and in Brazil in 1999, says HSBC’s Lubin. It relies on pre-announced exchange rate depreciation to anchor inflationary expectations.
But “to make these stabilisation programmes work, countries have to undertake a lot of fiscal reform and a lot of privatisation,” he says. Fiscal reforms during the last 18 months have benefited from one-off taxes on items such as lottery tickets and mobile phone usage. And many in the market are sceptical about whether fiscal reforms in 2001 can be sufficient to support the stabilisation programme.
There have been signs that the government’s commitment to reform is not as deep as it needs to be, says Lubin. Structural reforms have experienced some hiccups, notably over the privatisation of Turk Telecom, which will now not take place this year, as scheduled. That would have added some $2.5 billion to the government’s coffers. And some members of the ruling coalition have even started to question the need to privatise.
To try and make Turkey’s exchange rate-based stabilisation regime more viable than the failed ones of the past, IMF economists have come up with a rather more elaborate design for the programme. From next July, Turkey’s currency, which presently operates as a “crawling peg” system, will be allowed to float within steadily widening bands (expanding like a cone). In the meantime, there will be a kind of currency board regime that will restrict the creation of lira in line with the level of foreign exchange reserves. Despite its cleverness, it creates the conditions in which it pays market participants to “short” the euro and go “long” the lira. That leads to the kind of currency mismatches that proved so damaging to Mexico, Russia and Brazil, Lubin adds.
While Argentina and Turkey have been receiving most market attention, problems elsewhere are adding to general nervousness. These include the proposals to impeach Philippine President Joseph Estrada; political violence and economic deterioration in Zimbabwe; the use by South Africa of a mixed euro and dollar anchor for its currency, which is generating tensions around the rand; and Poland’s ballooning current account deficit, predicted to reach over 9% of GDP next year.
On the positive side, most emerging markets have been undertaking extensive reforms in recent years, and have built up strong foreign exchange reserves. They are, therefore, in a better position to withstand some market turbulence, says Mohamed El-Erian, emerging markets portfolio manager for California-based PIMCO, one of the world’s largest mutual fund firms. But the “more uncertain outlook has increased the potential for a general weakening of emerging market currencies”, he says. A significant fall in the Turkish lira is more likely than a devaluation of the Argentine peso, but the latter would be hugely more disruptive, El-Erian adds.
The head of emerging market foreign exchange trading at a major bank in London says Asian currencies are also being reassessed in the light of recent events, particularly the oil price rise. Higher energy costs will dent growth across much of Asia and slow the region’s recovery from the 1997-98 financial crisis. However, many Asian countries would prefer to see their currencies weaken a little, says StanChart’s Piron. They are anxious to maintain their competitiveness, particularly at a time when demand for their exports is slowing. But they have to find a balance between letting their currencies weaken and preventing the inflation that can often result. To achieve this balance, “what we are going to see is a lot of intervention [by the monetary authorities] in the currency markets and a lot of managed floating,” in coming months, Piron predicts.