With the U.S. a step closer to rate normalization, there’s panic brewing in emerging market countries with highest current account deficits and dollar external debt. The so-called “Fragile Five” of 2013 Taper Tantrum fame (Turkey, India, Brazil, Indonesia, and South Africa) are back in the spotlight, but with a big difference.
The Asian components of the group, Indonesia and India have bulked up their FX reserves by about 25%, and have seen their current account defects as a percentage of GDP decrease, indicating that their ability to withstand the U.S. taper driven currency, and thus drive up the cost of their external debt, has been stabilized.
Indonesia and India are not behaving like fragile economies at all in the second round, with their equity markets rising as they have seized the opportunity oil deflation and lower currency has provided for export growth and stimulative fiscal policies to generate higher growth with lower inflation (and thus higher real rates of interest — a further currency support in the coming normalization cycle).
On the opposite side of the spectrum of EM countries with large dollar funding needs there is Turkey, South Africa, and Brazil. As Bank of America wrote Wednesday in a report, “Turkey in Focus: There Will Be Pain”: “We believe Turkey has largely missed a great opportunity to ride on a strong cyclical tailwind. With more prudent policies, Turkey could have addressed its macro vulnerabilities smoothly with the Fed’s rates normalization looming. A global backdrop including a prospective increase in dollar rates and few dollars flowing into GEMs means Turkey will eventually go through a painful adjustment”.
Alarmingly, the politically driven Central Bank of Turkey does not see the prevailing danger and continues to cut rates, with another 100 bps of “stimulative” rate cuts expected against the backdrop of a weakening currency, rising inflation, and already negative real rates.
Turkey’s and Brazil’s markets have been most hit YTD. Looking at the most actively traded dollar ETFs for each country and the currency performance shows some dramatic divergences. The Turkish lira is down 9.5% and in dollar terms the market is down 12%. Brazil’s currency is fairing even worse as oil and steel continue to test new lows, with the Real down 18% and the Bovespa 12%. South Africa is fairing better with the Rand down 2% and the markets up 5.5%, with the modest rebound in precious metals. The Indonesia Rupiah is 4.8% lower and Indonesia ETFs are 1% slightly higher YTD. However, India has decoupled from the rest, with the Rupiah 1.1% stronger on the year and the India ETF +7.7% this year.
We believe, whether slightly faster or slower, U.S. rate normalization will come and continue to punish the weakest emerging market participants, namely dollar funders with high defects and low real rates. Only this time around the Asian components look significantly better prepared.
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