CHANCES ARE HIGH OF MASS EXODUS FROM EM / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

February 12, 2014 7:15 am

Chances are high of mass exodus from EM

By Gene Frieda

No framework for co-ordinating an orderly reversal of flows

The risks posed by emerging markets relate less to their own vulnerabilities than to deficiencies in the global financial architecture. Financial intermediation mismatches, volatility mispricing and co-ordination failure threaten a train wreck in emerging markets and an atypical spillover to the weakest developed economies.

Thus far, the most extreme asset market weakness has been concentrated in a few countries. Public debt levels generally remain low, as does external indebtedness. Flexible exchange rates and large foreign reserve cushions are serving their traditional buffering role, thereby limiting the more egregious effects of capital flow reversals. And gross domestic product growth, while weaker than in the immediate post-crisis years, is hardly disastrous.

Then why are the emerging markets suddenly under pressure, with interest rates rising sharply, and why have developed country asset markets started to express concern?

Driven down to unprecedented levels during the past five years, real interest rates need to rise substantially across the emerging markets.

During the period preceding the 2008 global financial crisis, foreign capital inflows reached 15 per cent of GDP for the median emerging market country, and remained sizeable after the launch of the US Federal Reserve’s quantitative easing programme. Real interest rates in many emerging markets fell sharply, often to negative levels. In response, private credit growth boomed, following the same pattern as the eurozone periphery and central/eastern Europe a few years earlier. Only after real interest rates normalise will it be clear how much boom-time credit turns into bad debt.

On its own, the above story points to an overdue adjustment rather than a crisis. Instead, the global risks relate to two systemic policy challenges posed by the reversal in capital flows to emerging markets.

First, current low levels of volatility mask the degree of potential “risk”. As exchange and interest rate volatility fell during the 2000s, capital flows well exceeded emerging market GDP growth. Financing constraints eased, and whereas previously a 3 per cent of GDP current account deficit was considered the upper limit of “safe”, a number of countries could now run 5-10 per cent of GDP current account deficits with relative ease.

Volatility should rise, and potentially overshoot, as the US exits its unconventional monetary policies. Rising volatility across global markets forces a reduction in emerging market asset holdings for a given value-at-risk constraint, and this is exacerbated as diversification benefits across countries disappear. This toxic cocktail of rising volatility and a reversal of correlations undermined portfolio insurance strategies in 1987 and led to the failure of Long Term Capital Management in 1998.

In current circumstances, such a trigger could reveal a second problem: a systemic liquidity mismatch. Market prices could plummet and interest rates rise as investors flee emerging markets without the traditional buffering role played by bank dealers, whose market-making capacity has been hollowed out.

While the regulatory response to the 2008 financial crisis sought to reduce systemic banking risks, changes to financial regulation have further reduced the intermediation capacity of the developed countries’ banks, and indeed of their subsidiaries within the emerging markets.

Relative to past cycles, capital flows over the past decade were larger and concentrated in local currency debt. Non-resident holdings of local currency emerging market debt surpassed $2.5tn in 2013, up from $637bn in 2008. While emerging market governments benefit from borrowing in local currency, foreigners now carry unprecedented risk exposure. 

In past emerging market crises they bore only the credit risk on foreign currency denominated debt. Now they bear currency and convertibility risk, together with a large degree of interest rate duration risk.

The disparity between the mountain of assets invested in less liquid emerging markets and risk-averse financial intermediaries will lead to periods of illiquidity, where investors encounter difficulties in liquidating positions, and contagion, where they are forced to sell more liquid assets in unrelated markets.

Taken together, one can spot elements of the 1987 Wall Street crash, the 1998 Asian-Russian crisis and the 2008 financial crisis in today’s financial market landscape. Concentrated common lenders, together with mispriced volatility, correlation and liquidity risk create contagion risk within and beyond the emerging markets. They influence the extent to which real interest rates will need to adjust, the potential credit losses associated with the rate adjustment and the distribution of losses.

It is in no one’s interest that creditors beat a hasty retreat or that debtors (or indeed asset managers) impose controls to prevent that retreat. Because the potential fallout is more of a market risk than a fundamental macro risk for developed economies, the odds of pre-emptive co-ordination by major central banks or the IMF are reduced.

Emerging market countries and investors alike face a potential prisoner’s dilemma: co-operation is optimal, but with no framework for co-ordinating an orderly reversal of capital flows, the chances of a mass exodus are high.


Gene Frieda is a global strategist for Moore Europe Capital Management

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