Wednesday, 7 August 2013

Developing Crisis

The story of ‘hero becomes villain’ is all too familiar. From page to screen, characters such as Macbeth, Annakin Skywalker and Lotso’ Huggin the Strawberry Bear, have all been undone by their own ambition*. Sadly, such a volte face is equally common in the financial world with Emerging Markets, once the darling of the investment community, the latest asset class to suffer a sharp fall from grace. But how can it be that these areas with such vastly superior growth rates, and lower levels of debt, are now on the cusp of a potential crisis? First and foremost, this turn of events has not caught us offside, having been discussed at length in previous blog posts.

Back to the present, however; one of the major sources of concern surrounds current account deficits. Using the Balance of Payments calculation a country enduring a current account deficit is likely to be importing more than it is exporting. In order to ‘balance the books’ either a country must sell down its foreign exchange reserves to pay for the surplus goods, or it must attract a sufficient combination of Foreign Direct Investment (FDI) and investment portfolio flows to plug the gap. Whilst there are other components in the Balance of Payments equation, this broad thesis stands up credibly. Foreign Direct Investment is a direct investment into a country’s operations (or expanding operations) of business. This is considered a more stable source of funding than the more flighty portfolio flows into a country’s stocks and bonds. The following chart highlights several of the major Emerging Markets, referencing their current account position and FDI as % of GDP averaged over the past 3 years.



The above details how countries such as Turkey, South Africa, India and Brazil are running persistent current account deficits. It also highlights the low contribution from FDI. Our conclusion from this is that many of the larger emerging markets are funding their account deficits through increasingly risky means, such as portfolio flows. Any reversal of such flows could, therefore, rapidly turn into a Balance of Payments crisis, precipitating a potential currency collapse.
Currency weakness is a particular headache for Emerging Market policy makers as to concede to market forces would generally lead to a significant rise in inflation. And burdening the populace with ever higher food and energy costs has rarely been a formula for success.
In order to shield citizens from the painful affects of inflation, policy makers will, instead, attempt to defend currencies through monetary measures. This can include selling down foreign exchange reserves and buying back your own currency. This is only an option, however, if reserves are plentiful. Regardless, by extracting your own currency from the financial system, liquidity levels are tightened - impeding growth.
Another policy commonly employed to protect a currency is to attract/retain yield hungry investors by hiking interest rates. Such efforts will also raise domestic borrowing costs, however. Whichever method is employed to support the currency, therefore, the growth outlook deteriorates. In fact, we have seen both Turkey and India initiate variations of interest rate rises in order to prevent capital outflows.
Sadly, if we look at government budgets, it doesn't appear administrations are behaving with any real sense of discipline either.



This leaves governments with an equally difficult choice; apply budgetary restraint or fear spooking foreign creditors. But we have already seen how attempts at fiscal rectitude, such as bus price rises in Brazil or Indonesian fuel price hikes, have been met with angry response from the electorate. It is amidst these most uncertain of times that the threat of crises looms. At least China’s monetary and fiscal flexibility remains potent. Sadly, however, it appears an agenda of reform renders this armoury somewhat sidelined for the time being.
*For those not familiar with all these fictional characters, MacBeth is from a Shakespeare play.

Ben Gutteridge, CFA
Divisional Director

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