Changes in US monetary policy are putting pressure on emerging markets economies, with the result that many will look to diversify their dollar dependency and possibly strike up new alliances, which carry risks of their own. Silvia Pavoni reports.

US policy EM

The rise in US interest rates is hitting emerging markets by denting these countries’ ability to serve existing dollar-denominated debt and hence to finance future activities. International investors are in turn moving away from riskier issuers to safer, better-yielding US paper. With record levels of emerging market (EM) debt – and, in some countries, over-indebtedness in foreign currency – this is a serious issue. 

Even more serious, however, is the impact of the US’s rather volatile approach to international relations. Any threat to emerging countries’ economic stability could encourage them to insulate themselves from the US-dominated global markets by striking new geopolitical alliances. While this might lead to positive outcomes, such as the development of regional insurance agreements and local capital markets, it also opens up emerging markets to new risks.

Turkey’s crisis

The recent case of Turkey exemplifies the problem, where “geopolitics and economics are feeding off [each other] in a negative spiral that could make things a lot worse that they need to be”, according to Eswar Prasad, professor of economics at Cornell University and a senior fellow at research group the Brookings Institution. “Fundamental problems are of the countries’ own making [and] the effect of US monetary policy can serve as a trigger. But certainly the wild card here is the reaction of the US administration [to perceived threats].”

A high dependence on dollar financing, a mismanagement of the economy and a lack of central bank independence over interest rates decisions have made Turkey particularly vulnerable. Pressures on the Turkish lira are not new, but were exacerbated by the public dispute with the US – accompanied by related sanctions and trade tariff retaliations – over a US pastor jailed by Ankara over allegations of spying. These developments threw the lira off a cliff, knocking a fifth off its value in a week; as at August 17, it was 38% lower than at the beginning of 2018.

Turkey’s foreign currency-denominated redemptions account for 47% of the total that will mature by the end of 2019, according to the Institute of International Finance (IIF). With Ankara cut out of the international bond markets (“I cannot possibly imagine any single buyer of Turkish debt right now,” says one observer), the country is likely to seek funding alternatives and forge new alliances in the process. 

Qatar has already committed to providing $15bn in direct investment in Turkey. Meanwhile, experts say China and Russia are potential supporters but believe that Turkey would need $200bn a year in overseas investment to keep its economy going. Analysts say that while either potential ally might lack the financial muscle (or the will) for a bailout, the lira crisis is accelerating the creation of new economic axes.

The situation has also sparked fears over potential contagion to other emerging markets, as seen in the meltdowns of 1994 and 1997 that followed currency crises in Mexico and Asia, respectively. The IIF has recorded a $1.4bn portfolio outflows from emerging markets between August 9 and August 15 alone, following Turkey’s recent woes.

Unintended consequences

Regis Chatellier, EM strategist at Société Générale, says such surprises may become par for the course. “Turkey is a reminder that you can have unforeseen circumstances affecting international markets and that, because of the more unpredictable foreign policy of the US, you can have surprise effects in emerging markets. That’s a new norm,” he says. 

Anthony Morton, partner at law firm Norton Rose Fulbright, adds: “The bigger picture is the potential damage that the increased levying of sanctions [on Turkey by the US] and trade tensions could have on the global economy. Trade tensions are not a regional issue but a global issue.”

Turkey’s predicament is unique in many aspects, but nonethless serves as a clear warning on dollar refinancing issues in the current environment. In those terms, some EMs are in even worse condition than Turkey: Argentina, Colombia, Egypt and Nigeria’s foreign currency redemptions, for example, account for three quarters of total debt; Mexico has a ratio of 62%, while South Africa and Brazil are at 57% and 50% respectively.

According to the IIF, about $900bn in emerging market debt is denominated in foreign currency and due by the end of 2019. While fears of wider contagion have subsided, strong localised tremors can occur. In Argentina, the central bank was forced to raise the benchmark interest rate by five percentage points to 45% as a consequence of the Turkish affair, which amplified the effects of a local corruption scandal on an already declining peso. There was a clear difference between the two cases, however: while Turkey’s central bank had its hands largely tied, Argentina’s could move freely and promptly. The country was also able to secure a $50bn International Monetary Fund bailout loan earlier this year after the central bank had made substantial use of its foreign reserves to prop up the local currency.

A protective stance

As US interest rates rise and president Donald Trump engages in various diplomatic spats, EM central banks are likely to accelerate attempts to insulate their home markets from changes in global conditions. The position they take will be important, according to Andre de Silva, HSBC’s head of global EM rates research, whose praise is not limited to Argentina. 

“It’s not just the external environment but also how to respond to the external environment,” he says. “Indonesia, from late April to mid-May, has had quite heavy outflows to the tune of just over $3bn of local government bonds. We’ve seen the central bank respond with rate rises, which I consider proactive. Inflation was at the bottom of the target and therefore it was responding to confidence issues rather than domestic issues [such as a rising inflation rate].”

Given the size of its market and the rule of law that defines it, the dollar is irreplaceable, but confidence in it as a protective currency has arguably been weakened by the tone taken by the US leadership. World leaders have responded not just with words but with practical and meaningful measures. Central banks may also have a solution to wider concerns. 

“Russia recently made a threat to dump dollar-denominated bonds [in protest against US sanctions on Turkey and itself. Even if, say] China were to threat to take $100bn out of the US treasury market, the logical question would be ‘where are they going to put it?’, and there isn’t an answer to that,” says Mr Prasad. Nevertheless, he adds: “Certainly one thing that will happen is that rather than holding foreign exchange reserves, countries will look at either self-insurance or regional insurance mechanisms so that they can protect each other better [from international capital flow volatility] without having to rely on large amounts of reserves held in dollars.”

One example is the large amount of bilateral swap lines that the People’s Bank of China (PBoC) has signed with a number of central banks in emerging markets and advanced economies. The PBoC has swap arrangements with a total of 36 countries worth $508bn, according to data collected by Mr Prasad.

On the back of its own currency’s steep decline, Argentina is negotiating an extended swap line with the PBoC, building on the existing $10.37bn agreement.

In addition to China’s, there were five bilateral swap lines between emerging market central banks and 10 swap lines between EM central banks and counterparts in developed markets in 2017, says Benn Steil, senior fellow and director of international economics at the US Council on Foreign Relations, which has set up a tracker of such agreements.

Furthermore, the 10 members of the Association of South-east Asian Nations plus Japan, China, South Korea and the Hong Kong Monetary Authority have established the Chiang Mai Initiative Multilateralisation (CMIM), a multilateral currency swap arrangement under which each party sets aside a certain amount of funds that can be drawn upon for swap transactions by other members. The CMIM was set up in 2010 as an evolution of bilateral agreements between these countries that had developed since the 1997 Asian crisis, to supplement existing international facilities. In 2014 its initial value was doubled to $240bn.

Diversification of interests

Other groups of nations might follow, such as the Economic Community of West African States, which is considering a similar initiative, says Mr Prasad. He notes, however, that Latin America seems too engrossed in country-specific political challenges to address the issue as a region.

“As we look to the future, Turkey and other countries see that the US cannot be trusted [as a backstop] if the economic interests don’t fully coincide – and in [Turkey’s] case, one would have thought that the economic interests are not that far apart but things got tangled up with a lot of other political issues,” he says. “That is going to lead to other countries, perhaps not distancing themselves from the US but at least trying to diversify their geopolitical attachments.” This would also affect relations between monetary authorities.

International organisations also have a role to play in helping emerging markets to manage their liabilities, says M. Coskun Cangöz, head of government debt and risk management at the World Bank. His institution, for example, rescued Uruguay as the Latam sovereign sought to protect itself from US interest rate rises and converted dollar-denominated liabilities into pesos.

Uruguay had been reducing its exposure to foreign currencies by increasing the percentage of local currency in its debt portfolio, but the limits of the domestic swap market posed a problem. So the World Bank issued a Uruguayan peso-denominated bond and exchanged the pesos it received from investors for dollars with the Latam sovereign, say Rebeca Godoy and Dolores Lopez-Larroy, senior finance officers at the World Bank’s treasury division. The $21m deal secured an interest rate for the conversion more than 30 basis points lower than the rate the Uruguayan government could have funded in pesos for the same maturity, at 9.33%, according to the World Bank. Being able to rely on deeper local capital markets would, of course, have been preferable.

Better shape, bigger needs

Overall, emerging markets are in better shape than they were two decades ago, or even since the 2013 ‘taper tantrum’ crisis, which hit them particularly hard, says William Jackson, chief EM economist at analyst Capital Economics.

“Back in 2013, there was a lot of focus on what were quite large current account deficits in a few emerging markets. One was Turkey [again, and] there were tensions in Brazil, India, Indonesia and South Africa,” he says. “Now current account deficits in those countries are much smaller. Whereas when the taper tantrum hit it affected quite a few emerging markets, this time around, [while] there has been turmoil, it hasn’t really affected the big EM economies in the same way.”

Mr Jackson adds that much more debt has been issued in local currency than in foreign currency, risks are also better understood, and there is more hedging against those risks. But he is concerned about the overall size of EM debt. Excluding financial companies, EM debt reached a new record in the first quarter of 2018: $58,500bn, according to IIF data. Government debt has risen most sharply in Brazil, Saudi Arabia, Nigeria and Argentina, where the IIF expects interest expense, on average, to reach nearly 2% of gross domestic product (GDP) in 2018 and 2019. The exodus by international investors is a concern, particularly when they cannot easily be replaced by local ones; a slim local investor base is an intractable and frustrating issue.

Some Asian countries such as Indonesia, Thailand and Malaysia have made progress in improving local currency markets for government bonds, says IIF head of global capital markets Hung Tran. 

But many others still struggle, adds Jingdong Hua, treasurer of the International Finance Corporation (IFC), the World Bank’s private sector arm. At July’s IFC Capital Markets Pacific Alliance conference in Lima, he drew a parallel between Malaysia and Peru, which have similarly sized populations and level of economic development. “But Malaysia now has a corporate bond market that is about 45% of GDP [GDP being over $300bn in 2017], so you’re talking about $130bn connecting [the country’s] savings and the private sector. While in Peru, the corporate bond market is 5% of GDP,” he said.

With Peru expecting GDP of about $220bn this year, raising that five to 20% would direct almost $45bn towards financing economic activity, which would have the additional value of being denominated in local currency, he said. Developing a local investor base is not only an efficient way to finance economic activity, it also offers less volatility. But there is an undeniable downside to this: that better-functioning capital markets usually mean more open capital markets, which are therefore more vulnerable to the whim of international investors.

Easy come, easy go

At times of global low yields, investors tend to gravitate towards those well-developed local markets because they are also the easiest to enter and exit. Conversely, when global yields improve, large outflows from those markets can happen suddenly and dramatically. 

“Malaysia is a prime example of this,” says Cornell University’s Mr Prasad. “During the quantitative easing period, Malaysia got a lot of money – and Thailand did as well – because they had reasonably well-developed markets and it’s easy for investors to [access them]. And then when the taper tantrum hit, you had a lot of money going out: not because Malaysia or Thailand did anything hugely wrong, although they made some policy mistakes, but [because] those are just the easiest markets to get into [and out of].” 

Mr Prasad recalls being confronted about this by a top official at an emerging market central bank, who said: “You economists tell us that deep fixed-income markets are one way of ensuring stability, but if you have very deep financial markets sometimes that simply adds to volatility.” Nonetheless, deeper local currency markets and a large investor base remain indispensable in supporting emerging economies as global conditions change.

The US’s interest rates, currency and monetary authority will doubtless retain their global influence in the future. Indeed, the Chiang Mai lines have never been used because of certain conditionalities that made it easier, for example, for South Korea to borrow $16.4bn through its swap line with the US Federal Reserve than to use the regional bilateral lines during the financial crisis, according to the Council of Foreign Relations’ tracker.

But protective moves against deteriorating global conditions are likely to strengthen, whether through a push towards deeper local currency capital markets, by recourse to international financial institutions such as the World Bank, or by forging new alliances that inevitably will bring closer not only economies but monetary authorities too. This could open up new opportunities, as well as new risks.

“I don’t think this is going to be a blown-up [emerging market] crisis in the end, but I think it’s going to be a bit of a different world, with some EM countries trying to be more independent from global funding markets,” says Société Générale’s Mr Chatellier.

Meanwhile, Mr Prasad predicts that most countries will be looking to develop strong economic and political relationships with other superpowers, especially China, given its economic clout. But, he adds: “I suspect that even the countries that are going closer into China’s economic and geopolitical embrace are not necessarily going to do it because they trust China more, but simply because they feel the need to diversify away from [their] very close attachment to the US.”


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