This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Derry Pickford, Macro Analyst, Ashburton Investments discusses the volatility in emerging markets.
Recent bouts of volatility have put the spotlight firmly back on emerging markets.
Dramatic currency and stock market falls have made headlines since the US Federal Reserve first hinted at tapering its quantitative easing programme back in May 2013. So far 2014 has seen similar bouts of volatility, notably affecting emerging markets such as Turkey, South Africa and Ukraine. So what’s happening to upset the emerging market apple cart? Are these isolated events simply part and parcel of emerging market investment?
Self-contained
The popular image of emerging markets is that contagion is an endemic problem – if one emerging market falls, they all go down. In fact, statistically emerging markets have more of their own idiosyncratic drivers than developed markets do. Crises in developed markets may be fewer, but they’re more likely to spread to other developed markets.
Many of us are guilty of considering emerging market economies ‘en masse’. Perhaps this mind-set is a result of well-publicised terms such as the BRICS, CIVETS, the ‘Fragile Five’ or the ‘Vulnerable Eight’ - or quite simply an old fashioned divide between ‘developed’ and ‘developing’. Regardless, taking a broad brush view of emerging markets is no longer effective – it’s important to differentiate between emerging market economies, making country by country judgements. These are diverse economies at very different stages in their monetary cycles.
Policy Approaches
Amidst this diversity, many emerging market countries do face developmental challenges. This is especially true where fiscal and monetary policy is concerned. In South Africa, growth potential is significant, but the policy mix is yet to strike the right balance. In Brazil, fiscal policy is very loose, yet the central bank has been disciplined in keeping inflation within its designated band. Turkey, on the other hand, adopted very unorthodox monetary policy when it was suffering from a surge of capital inflows. Rates were cut too far, and even when the economy began to stabilise, no action was taken to rein policy back in.
Another example where loose fiscal policy prevails is India, the monetary policy failed to deal with a pick-up in inflation. With Indonesia also demonstrating poor supply-side policy and struggling with a divided labour market, it’s clear that policy hurdles are widespread among emerging markets – and lessons are still being learned by many developing countries’ leaders.
Mistakes of the past have been taken on board. The 1997 Asian financial crisis highlighted the dangers of allowing banks and governments to borrow cheaper external currency: namely that jumps in the foreign currency can significantly increase the value of the underlying debt.
Unlike in 1997, exchange rates are now largely floating rates. This has encouraged FX hedging of foreign currency denominated borrowing. FX reserves are typically much larger and because exchange rates are no longer pegged, they are less likely to be frittered away defending an unsustainable rate.
However, we should be far from complacent. Borrowing in external markets by non-financial emerging market corporates has increased significantly, particularly in India. According to research by the Bank for International Settlements, a large proportion of this borrowing is being carried out by offshore entities. If external borrowing is repatriated it’ll show up in the balance of payment statistics as foreign direct investment (FDI). Investors should be aware that if large proportions of quoted FDI figures are in fact corporate borrowings being repatriated by offshore entities, these flows could potentially reverse.
Food for Thought
While it may seem that investors have many points to consider when it comes to emerging markets, there are some strong positives supporting the rationale for investment. Default risk in these markets has come down substantially in recent years and a number of emerging markets have FX reserves greater than their external debt, with current account positions that are benign. Even if we get capital flight, as long as these countries do not try to defend their exchange rates too aggressively and allow moderate depreciations, they should avoid any crisis situations.
One of the best times to invest in emerging markets is actually when scepticism about emerging market economies is at its highest, as this is reflected in valuations. Not all emerging markets represent good value for money today, but there are certain types of assets which aren’t pricing correctly in the macro-environment – these ‘dislocations’ are a great opportunity for investors.
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