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Will emerging markets be the source of the next crisis?

Published at: 28-11-2021

Posted on: November 28th, 2021 by RaduC No Comments

After a long period of “blue sky” when any sign of a dark cloud was removed by the extremely low central bank interest rates and by investors’ frantic exhilaration (irrational, some would venture to say), emerging markets have started to become a serious cause for concern.

Firstly, the overall macroeconomic landscape is about to turn sour as the Fed did a U-turn. Faced with the highest inflation rate in 31 years, its belief that we are merely going through a transitory high inflation is about to be dispelled. The last policy-setting FOMC meeting earlier this month that foresaw a tapering of treasury purchases by USD15Bn a month seems now irrelevant. The Fed’s vice-chair was recently suggesting that the next meeting might provide for a faster than announced withdrawal.

Under the scheme announced at the beginning of the month, the withdrawal should have been completed by the end of 2022. Bringing now forward the date by which the Fed stops bond buys would allow for faster interest rate hikes once purchases are down to zero. Indeed, re-appointing Jerome Powell for a second term as Federal Reserve chair immediately pushed stocks downwards as stock markets expected decisions to move towards tighter monetary policy.

Such a policy shift is vital to emerging markets given their high level of debt. Once the Fed starts increasing interest rates, financing and refinancing costs in USD would rise to new levels and the the pace would only pick up as the inflation rate in the US peaks. The countries that have been relying on enduring minimum financing costs will wake up to the harsh reality of painful corrections that cause stagnation if not a downturn. In the most extreme cases, some may have to restructure their foreign debt, penalizing investors and thus increasing risk aversion.

But beyond the overall negative context, some emerging countries are case studies that force investors to back down. China provides a first example as political developments headed towards stricter controls of the private sector are taking a toll on the country’s risk profile. Meanwhile, the Chinese real estate bubble remains a major concern given the high level of debt financing across the industry with foreign bond issues accounting for the bulk of that debt.

There is now a strong belief that a default by such an issuer will not trigger a government bail-out to help repay a debt to foreign investors. A moment of truth will therefore be the spring of 2022 when USD2bn worth of debt reaches its maturity in March and another USD1.5bn tranche is set to come due in April.

Turkey is next in line. In the last two weeks the Turkish lira has plummeted by 20%, sparking street protests. This was the result of what we could call politely as “unorthodox” monetary policies, whereby rising inflation is dealt with by the central bank with falling interest rates. It thus echoes the Turkish president’s economic thinking according to which it is high interest rates which cause higher inflation. Turkey’s president had to fire several governors until, lo and behold, he found one to follow his beliefs. And the results are clear…

Beside the risks related to a stronger dollar or rising interest rates, the lack in budgetary discipline in the big emerging countries, under the pretext of the pandemic but fueled by a healthy dose of populism, is making investors demand higher risk premiums. Thus, countries such as Brazil or South Africa are financing themselves at interest rates of 12% and 10% respectively, over 10 years while Russia, despite strong budget revenues, is financing itself at a rate close to 9%. And the bad news is that it is not only in Turkey that central banks are under siege.

The Mexican president put pressure on financial markets by unexpectedly nominating for governor a person totally unknown but close friend instead of a former finance minister that investors preferred on account of his expertise. As a side note, last Friday the peso was the worst performing emerging currency.

And to complete the clearly negative picture presented by emerging markets, we will also take a look at Central Europe, which lately has been losing the trust of the financial community for political, geopolitical and economic reasons. On the one hand, tensions between the Hungarian and Polish governments and the European Commission are growing over the rule of law and the principle of the primacy of the EU law while tensions on the Polish border with Belarus are an additional cause for concern over the regional geopolitical stability. Romania’s shaky political situation is another piece of the puzzle.

Reuters rightly observed that Hungary’s forint, the Polish zloty, Romania’s leu and Russia and Belarus’ roubles are five of the eight worst performing world currencies this month. But news keeps getting worse. Racing inflation rates put Poland, Hungary and Romania at the top of yet another negative list. The negative real interest rates (adjusted to inflation) of their bonds present some of the widest gaps against inflation across emerging countries. There is growing concern that central banks are behind the curve when dealing with inflation. The problem is that as inflation is increasingly believed to spiral out of control, funding the region’s foreign debt using local currency could become more and more expensive. Thus, in a vicious circle, budget deficits will be even harder to correct. And Romania missed a very good opportunity in 2021 to make such a correction.

Emerging countries give us far too much cause for concern not to wonder whether the critical mass needed for a crisis will not be reached. A few national crises or a regional one is all it takes for investors’ herd mentality to kick in.

Have a nice weekend!


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