Emerging discrimination

Between May 5 and June 23, Turkey’s lira fell by 23% against the dollar, the biggest loss that the country’s currency had experienced since the devaluation in early 2001. Other emerging market currencies soon registered some miserable declines, including those of Brazil, Indonesia, Colombia and South Africa. Then Hungary’s forint wobbled; in June it fell 7.4% against the euro. An emerging market (EM) sell-off was under way and the talk was all about contagion; the gloomy ghost of previous EM meltdowns hung over the market.

But this time it is different because nobody is talking about default, argues Bart Turtelboom, co-head of emerging markets within fixed income at Morgan Stanley. “In 2001-2002, during the crisis in Turkey, there were serious concerns about the country’s creditworthiness. We have just had a currency move in Turkey that, in magnitude, comes close to that move then, but nobody is saying that Turkey may default,” he says. “People may say Cyprus is an issue or the elections are an issue but, despite a very large currency move, nobody is worried about default.

“In Brazil, people may worry that spreads will widen; they may be concerned about economic policies; they may be bullish or bearish, but they do not think that Brazil is going to default. The fact that the fear of default has been taken out of the equation is of profound importance.”

Signs of a new era

Arnab Das, global head of emerging market research at Dresdner Kleinwort, agrees. He says the recent volatility smacks not of the same old EM story but the beginning of a new era in emerging markets. “We are seeing the end of systemic emerging market event risk and the beginning of country-specific, idiosyncratic market risk,” he says.

Contrast the recent mini-crisis with the repercussions from the east Asian financial crisis in July 1997, he says. Then, the effect quickly spread beyond the currencies, stock markets and other asset prices of directly affected countries, and political upheaval came fast on the heels of economic crisis. EM investors stopped lending, leading to slowdowns. Plunging oil revenues contributed to Russia’s problems and hastened in default on its domestic debt.

Russia’s emergency measures were accompanied by declines in international markets: equity market declines were recorded in all 23 of a group of the main emerging financial markets – varying from 10% to over 25% in more than half of the sample. By 1999, Brazil had been forced effectively to devalue the real, and Ukraine and Turkey went into crisis. Turkey had another crisis and devaluation in 2001 and was joined in that year by Argentina, which defaulted on its external debt.

The volatility in May and June shows marked differences, says Mr Das. “Firstly, it was driven not by an event in an EM economy but by fears about inflation, rising interest rates and policy credibility in the US.”

Then there is its brevity – the crisis was fairly short-lived – and relative containment. “There was an initial round of contagion, and that was indiscriminate on May 10 and 11, and maybe 12. But investors soon began to discriminate between countries,” says Mr Das. “Look at the difference between Brazil and Turkey, for example: Brazil’s current account surplus and real economic flows put a floor under the currency, even as speculators were unwinding their carry trades, but there wasn’t this kind of support in the case of Turkey, which has a big current account deficit.”

Discrimination grows

Investors’ growing discrimination is clearly demonstrated in emerging markets FX, he adds. Undistorted by technical drivers (such as the way in which strategic asset allocation and diminishing issuance can affect the bond market), returns from EM foreign exchange demonstrate that in the first half of 2006, it was fundamentals – current account balances – that drove the market, instead of the untrammelled yield-seeking behaviour that was a key determinant of excess returns in 2005 (see figure 1).

“This illustrates the mounting discrimination between countries by EM investors. They are increasingly driven by idiosyncratic market risk – in this case, that some countries have generated capital gains and others losses – instead of systematic event risk, in which every EM country sees investors’ money flowing out.”

So what has caused this fundamental shift? There have been several concurrent trends. Part of the story is a benign environment: emerging markets have been some of the major beneficiaries of the huge flood of global liquidity as the US reduced its net asset position to the world; and a huge rise in commodity prices has enabled countries such as Venezuela and Russia to build up their international reserves.

Many EM countries have also drastically improved their fiscal and monetary policy credibility since the period of the 1990s crises. They have moved from fixed to flexible exchange rate regimes coupled with inflation targeting and, as investors gained faith in policy credibility, they were able to issue more local currency debt and develop domestic markets (see figure 2). In some cases, they have pursued aggressive foreign debt buy-back programmes – the outstanding amount of Brady bonds, for example, has declined from a peak of $150bn face value in August 1996 to a little over $10bn in April 2006.

“Few countries still display the traits that characterised all the EM countries at the time of the 1990s meltdowns: fixed exchange rates, large current account deficits, often large fiscal account deficits, financed with external debt (often short-term) with the inevitable currency mismatches. Increasingly, different countries have different fundamental and financial characteristics, which means that in a market shock they will behave differently and be treated differently,” says Mr Das.

And today, most of the major EM borrowers have higher ratings and some are new members or candidates for the EU, he adds, and hence are likely to face less severe constraints on their capacity to borrow; while the lower grade countries generally have export-led growth and current account surpluses. “EM countries as a whole are therefore less exposed to global financial volatility, though of course many are exposed to global demand and growth.”

Resilience improvement

Jerome Booth, from Ashmore Investment Management, suggests that if the fiscal discipline imposed by a floating exchange rate mechanism (which forces a country to cope constantly with change in the currency market) helps policy to react to the market and reduce the risk of major imbalances building into a balance of payments crisis, then issuing debt in local currency greatly improves a country’s ability to cope with instability and external shocks. A country that is able to issue large amounts of debt in its own currency has passed the biggest test in its capital markets development, he says.

“Aside from all the benefits it offers in terms developing a country’s own financial infrastructure, it reveals a level of market confidence in its long-term future, which greatly reduces its vulnerability to external shocks in the near term. And, because the risk of external shocks is reduced, governments have more policy options available to them if they are faced with balance of payments crises,” says Mr Booth.

Hot money flows

There is further evidence that emerging markets, and their relationships with investors, have matured. Christian Stracke, senior analyst, emerging markets strategy, at capital structure analysis firm CreditSights, regularly tracks portfolio flows or ‘hot money’ (so-called because it tends to move out quickly in a crisis). The latest survey, published in August, shows that inflows to EMs reached $41.4bn in Q1 2006, on a par with the previous record for inflows in a single quarter – $41.1bn in the second quarter of 1997.

As the latter was followed by the Asian crisis, the Q1 2006 inflow was followed by the mini-crisis in emerging markets in the second quarter. However, this paled in comparison with previous crises, says Mr Stracke. And, although the size of the outflows was greater (CreditSights estimates as much as $20bn left emerging markets in hot money outflows during this year’s crisis versus just $7.5bn in outflows in the fourth quarter of 1997), the damage was much less extreme.

“We have argued for some time that EMs were, with some important exceptions, fairly well prepared for a wave of hot money outflows,” says Mr Stracke. “Sure enough, they proved highly resilient to the round of selling that came in May to June, although many of the exceptions we have highlighted in previous surveys were hit fairly hard, including Turkey, South Africa and Hungary.”

The second quarter’s outflow is the second-largest outflow on record for EMs since Mr Stracke began tracking them in 1994 and is only beaten by those of Q3 1998 (an outflow of $20.3), when the Russia and Long-Term Capital Management crises were in full swing. “The ability for emerging markets to suffer such a massive amount of outflows in the second quarter with only a few battle scars to show for it is a testament to the successes of most central banks in building up international reserves to prepare for such crises,” says Mr Stracke.

In June 1997, the median EM country (the data does not include China) had reserves representing 222% of portfolio inflows that had come in during the previous 18 months, whereas in March this year reserves were 604% of the past 18 months’ inflows.

Mr Stracke’s survey also highlights that, in their “importance” to the developed world – which may indicate how quickly money flows out – portfolio investment flows into emerging markets are well below 1997 levels. In the 18 months to June 1997, the $170.7bn of inflows into EMs represented 1.02% of US and EU-15 gross domestic product (GDP). In the most recent survey, inflows still only represent 0.64% of US and EU-15 GDP, he says.

Transition period

Many people remain nervous, however, of proclaiming that this time it is different, even in the same breath as acknowledging that much has changed in emerging markets.

“We are in a transition period, where there remains a great deal of uncertainty. I don’t remember when the G3 central banks were last in synchronised tightening mode,” says Michael Hart, director, economic and market analysis, at Citigroup. “Yes, things have improved over the past four or five years, but they have done so in a very benign environment, which to some extent is unravelling. We are coming to the end of easy money and we may be reaching another inflexion point. In many EMs, the domestic savings constraint has not been overcome, they have attracted funds on the back of foreigners’ hunger for yield, and there is still a lot more money that could move out. We should therefore sound a note of caution.”

Mr Hart does, however, agree that EM investors are becoming more discriminating. “The superstructure of EM investing is changing. As liquidity drains away, and the yield differential becomes less compelling, there is a greater imperative to discriminate, not only between EMs and other asset classes, but within the EM class itself.”

It is relatively easy to see where the lines will be drawn, he says. “The first cut will be between oil importers and oil exporters, then between who has used oil receipts wisely and who has not. In that sense, Russia has done well, even Nigeria has, but Venezuela and Ecuador have not scored so well.

“The second cut will be between those countries that have large external financing needs and large current account deficits, and those that do not. This cut exposes Turkey, South Africa, Hungary and Slovakia, for example.”

Turkey has benefited from what Mr Hart calls a virtuous cycle, in which fiscal adjustment triggered capital inflows, which strengthened and stabilised the lira, which in turn encouraged disinflation, monetary easing and attracted further capital. But Mr Hart says that Turkey and others are now feeling the consequences of less liquidity. “Turkey’s economic prospects are at least partly based on global economic conditions over which it has no control – so its virtuous cycle could turn into a vicious cycle fairly easily,” he says.

Mr Stracke’s analysis of which countries remain vulnerable to further hot money outflows largely coincides with Mr Hart’s list of those that are most susceptible to a global slowdown. Turkey haemorrhaged $4.4bn of hot money outflows in May and June but, considering that it has been the recipient of $34.4bn of portfolio inflows since the end of 2002, there is plenty of potential for further outflows if the US continued to tighten its monetary policy, for example. At the time of going to press, Hungary, South Africa and some other emerging countries had yet to post their Q2 portfolio flow data, “but we expect them to show a similar pattern”, says Mr Stracke. “The stock of foreign hot money has been reduced in recent months but the reduction has been nowhere near sufficient to leave these countries protected from another wave of risk aversion from foreign portfolio investors.”

Step change in motion

Caveats aside, some sturdy commentators are immune to accusations of complacency or overconfidence. Mr Turtelboom, for one, is convinced that there has already been a step change and that the demise of an asset class will come eventually. “The notion of an emerging markets class will increasingly become a bit of a misnomer. With the huge range of private equity investors, global macro hedge funds, global real money managers and others all getting more and more involved in emerging markets, clearly the notion of an asset class where you have dedicated borrowers and dedicated lenders is disappearing rapidly.”

However, he says, that does not mean that things will never go wrong in emerging markets. “There will certainly be idiosyncratic defaults but that is no different from the G7. Obviously, there will be credit events in emerging markets, but the probability that several emerging markets will default simultaneously, or that the entire corporate sector of a country will disappear on the back of bad macroeconomic policies, or the probability of some massive systemic banking crisis is very small. The world is beginning to look very different these days.”