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Updated August 28, 2013, 6:42 p.m. ET
The U.S. Strike on Emerging Markets
Developing Countries Were Rattled by the Prospect of War in 2002, but the World Has Changed for the Worse Since Then
By LIAM DENNING
A looming war in the Middle East, the lingering legacy of a recent U.S. recession, and very low interest rates suggesting the next move must be upward.
Summer 2013, yes, but also summer 2002. For emerging markets, the outlook is darker this time.
Emerging markets have been melting in the summer heat. This week, with the Indian rupee and Turkish lira hitting record lows against the U.S. dollar, the focal point is expected U.S. military action in Syria.
Emerging markets have been melting in the summer heat. This week, with the Indian rupee and Turkish lira hitting record lows against the U.S. dollar, the focal point is expected U.S. military action in Syria.
By injecting fear into oil markets, Syria does exacerbate a problema facing several emerging markets: energy costs. Priced in dollars, Brent crude is still 22% below its 2008 peak. But in rupees, for example, it is around 25% above the 2008 high point.
Higher energy import bills widen current-account deficits menacing several emerging markets. Meanwhile, the threat of war encourages foreign investors to withdraw to safe harbors, draining away the portfolio flows required to plug the gap.
Higher energy import bills widen current-account deficits menacing several emerging markets. Meanwhile, the threat of war encourages foreign investors to withdraw to safe harbors, draining away the portfolio flows required to plug the gap.
The real threats to emerging markets, though, lie not in Damascus but in Washington and at home.
The MSCI Emerging Markets index underwent an initial correction of 12% in the month following U.S. Federal Reserve Chairman Ben Bernanke's indication on May 22 that the central bank could start scaling back its bond buys in September.
Foreign capital that helped plug current-account deficits in several emerging markets is being called home by the prospect of higher rates. Some $23 billion has flowed out of emerging-markets bonds since May 22, not too far short of the $30 billion that had flowed in since mid-2012, according to Barclays. This, in turn, raises local funding costs and stokes inflation via falling exchange rates.
Back in 2002, rumblings of a much bigger U.S.-led war were in the air and the federal-funds target rate, at 1.75%, didn't look like it could go much lower. Emerging stock markets were selling off, centered on worries about South America.
As it turned out, though, the MSCI index bottomed in October of that year. The Fed actually did go lower: The target rate was cut to 1.25% in November and to 1% in June 2003. Despite the Iraq War kicking off in March 2003, emerging markets began a spectacular bull run, quadrupling by October 2007—even as oil prices surged and the Fed pushed the target rate back up to 5.25%.
Despite the echoes with that similarly fevered time a decade or so ago, the world has changed. For one, the commodities boom that boosted large emerging markets such as Russia and Brazil has petered out. Even if oil spikes on Syrian conflict, the experience of recent years indicates this will undermine demand, either by crimping economic growth or accelerating the drive toward greater fuel efficiency or oil substitution.
Beneath this lies a more fundamental change. In 2002, investors could look forward to a five-year period in which emerging markets' economic growth averaged five percentage points more a year than developed markets. Today, looking ahead five years using International Monetary Fund estimates, the gap looks set to have shrunk to 3.5 percentage points.
What has changed is that, following the financial crisis, the developed world's ability to suck in imports from emerging markets, funded by credit, is greatly diminished. Rising U.S. interest rates will serve to keep a lid on that.
Without that tailwind, the structural challenges facing emerging markets are resurfacing, such as India's barriers to investment and Brazil's inadequate investment in infrastructure. The confused policy response to recent pressure on currencies, be it India's imposition of capital controls or Turkey's convoluted interest-rate corridor, heightens the sense that emerging markets are struggling in this new environment.
Barclays points out that while emerging-market sovereign yields fell during the last Fed-tightening cycle, as the next one looms, they have risen by around a percentage point on average already.
Syria adds to the pain, but emerging markets are fighting a different war already.
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