Where To Next For Emerging Markets?

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At the World Bank/IMF meeting in Lima in October, delegates spoke of little else but emerging markets. On the conference podium and at receptions, the fate of countries that, until recently, were considered the dynamos of the global economy dominated conversation. Opinions ranged from the apocalyptic to the quietly concerned, but most delegates agreed that emerging markets face one of their most critical challenges since the term was coined back in 1981.

To be sure, emerging markets have had their ups and downs in the past. Anyone who lived through the Asian crisis of 1997–1998 appreciates that the rise of emerging markets has been far from smooth. But the magnitude of the current predicament is different for a number of reasons.

“There are great opportunities as a result of the Chinese tourism wave. It is only in recent years that many Chinese have taken their first trip abroad.

~ Hyung Jin Lee, Baring Asset Management

First, despite some notable exceptions, emerging markets as a group appear to face significant problems, whereas previous crises have been region- or country-specific. Second—and more important—emerging markets matter more than they did in the past.

The reconfiguring of the global economy in the aftermath of the financial crisis of 2008 put emerging markets in the driver’s seat. Although the US has sprung back to life since then, emerging markets play a much bigger role today than they used to, accounting for 52% of global GDP compared with 38.3% just 15 years ago, according to global advisory firm Oxford Economics. As a result, when the emerging markets sneeze, the rest of the world is more likely to catch a cold.

TRICKIER ENVIRONMENT

Gloomy sentiment toward emerging markets has been reflected in sharply weaker capital flows in recent months. In its October report, the Institute of International Finance (IIF) said it expects 2015 net capital outflows from emerging markets of some $540 billion—the first time they have been negative since 1988. “Foreign direct investment, portfolio investment and commercial bank flows have all fallen from 2010–2012 levels, driven by increasing concern about emerging markets’ growth outlook,” says Charles Collyns, chief economist at the IIF. “This year the largest component of the decline has been the unwinding of dollar bank loans to Chinese corporates as the renminbi has weakened.”

The reversal of capital flows from emerging markets has potentially significant implications. Countries that run sizable current-account deficits and rely on external financing could face a damaging squeeze, according to Collyns, especially once the Federal Reserve begins to raise US interest rates. A faster-than-anticipated rise in US rates—such as might occur if inflation picks up, for example—could put further pressure on capital flows to emerging markets as these markets’ relative attractiveness wanes, for institutional investors and commercial banks alike.

Not all emerging markets are affected to the same extent. A recent Standard & Poor’s report entitled Who’s At Risk? notes that Turkey, Lebanon and Venezuela, followed by Hungary and Argentina, are the most vulnerable to a spike in global interest rates, given their high external debt relative to current-account receipts and foreign exchange reserves. The Philippines, China, Russia, Brazil and Peru are the least vulnerable, as their external balance sheets and financing needs are typically low.

PERFECT STORM

Two closely linked factors are principally responsible for making many emerging markets more vulnerable to shocks—both internal and external—while slowing their economic momentum: the apparent end of the commodity supercycle and the changing economic model of China, whose growth rate has slowed.

The commodities supercycle—a period lasting roughly from the late 1990s and early 2000s to a couple of years after the financial crisis, during which the price of oil rose more than 1,000% and that of copper almost 500%—is said to have ended in mid-2013. For many observers, the halving of the price of oil since its mid-2014 peak has put the demise of the commodities supercycle beyond doubt.

The supercycle was driven mainly by historic underinvestment in commodities production, which meant supply could not keep up with booming demand (largely from China). When it did catch up, prices fell, with inevitable consequences for commodity exporters. The IMF’s October 2015 World Economic Outlook predicts that weak commodities prices will subtract almost one percentage point annually from commodities exporters’ average economic growth rate over 2015–2017, compared with 2012–2014.

At the same time, commodities demand has fallen dramatically as China has shifted its economic model away from exports and growth has slowed, exacerbating price falls. The redirection of China’s economy toward consumption has been well flagged. However, the task is massive and, unsurprisingly, progress has been uneven: Hitting the 7% GDP growth target has proved difficult. In October, imports—largely raw materials and components sourced from other emerging markets— fell more than 20% in dollar terms compared with the year-earlier period, while exports fell by 3.7%, sparking alarm.

Sizable corporate debt in emerging markets economies also raises risk for some. According to the IMF, the corporate debt of nonfinancial firms across major emerging markets ballooned from $4 trillion in 2004 to well over $18 trillion in 2014.

Apart from Argentina and Ukraine, which are a case apart, there have been no sovereign defaults, no significant increases in corporate defaults, no runs on FX reserves and no balance-of-payments crises.

~ Jan Dehn, Ashmore Investment Management

S&P expects $692 billion of rated financial and nonfinancial emerging markets corporate debt—7% of the global total of $9.9 trillion—to mature between 2015 and 2020. A large chunk of that corporate debt is in US dollars (75%) or euros (8%). That means issuers may have considerable FX risk.

As the dollar has strengthened against emerging markets’ currencies—not least as a result of the devaluation by China (whose companies account for $73.3 billion of S&P’s total)—S&P argues that it will become harder for companies to service their debt. “Issuers in emerging markets face risks of subpar economic growth, continued low commodity prices, depreciating currencies and the imminent rate hike by the Federal Reserve,” says Diane Vazza, head of S&P’s Global Fixed Income Research Group.

However, Jan Dehn, head of research at Ashmore Investment Management, notes that although some of these issuers are exporters and therefore have US dollar revenues, others may have hedges. Still others (notably in China and Russia) know they can rely on extensive central bank liquidity, if necessary. As a result, the currency risk highlighted by S&P may not be as great as feared.