The U.S. Federal Reserve has initiated a long string of interest rate hikes and should soon give directions on how it intends to start selling assets on its balance sheet (quantitative tightening). In the past, such initiatives fared badly for emerging markets.
At the end of 1993, the Fed started hiking rates from 2.97%, eventually reaching 6.02% 18 months later in June 1995, causing the dollar to rise and investments to move back toward U.S. shores – arguably setting a detonator for the infamous South East Asia financial crisis of 1997. Up to that moment, everyone spoke of the “tiger” economies of Thailand, Malaysia, Singapore, South Korea and others where yearly growth ranged between 6% and 9%.
“As the dust settled, it became clear how badly damaged the tiger economies were by the financial crisis, recalls a recent article in the International Banker. The nominal GDP per capita between 1996 and 1997 had dropped by 43.2 percent in Indonesia, 21.2 percent in Thailand, 19 percent in Malaysia, 18.5 percent in South Korea and 12.5 percent in the Philippines. And stock markets had lost up to 70 percent of their value by early 1998.”
The “Tantrums”
Traumatic episodes in EMs happened again in 2008, and in 2013 during what has been identified as the “taper tantrum”. After then-Fed Chairman Ben Bernanke announced in May 2013 his intention of reducing the Fed’s quantitative easing program of Treasury and mortgage-backed securities purchases, conditions soured in a dozen major emerging economies.
Another “tantrum” occurred in 2018 when the Fed finally started to reduce its asset holdings, but this time, only two countries, Turkey and Argentina, suffered any significant damage.
Many problems coalesced in the 1990s to create a perfect storm for the South Eastern tigers: overheated investment, inflated stock market values and property prices, inadequate currency reserves, unsustainable pegs of local currencies to the U.S. dollar, and lack of financial oversight.
The 7% Test
Conditions today are very different, giving EMs much more resilience. One key component is currency reserves, which gives a country a buffer to absorb any damaging impact of rising U.S. rates and a strengthening greenback. A rule of thumb for adequate currency reserves, as popularized by Fed Chairman Alan Greenspan in 1999, is that a country should manage external assets and liabilities in a way to be able to live without new foreign borrowing for up to one year, which translates into 7% of GDP. In 2013, 8 of 13 developing countries were well below that threshold, but by the end of 2020, only 2 were.
“These emerging markets have higher central bank reserves, lower foreign-currency debt and smaller current account deficits”, notes the Dallas Fed paper, “This suggests that emerging-market balance sheets are in much better shape now than they were during the taper tantrum of 2013.”
The Brookings paper also notes other sturdier points in EMs: in 2013, among the most fragile countries, current-account deficits averaged about 4.4% of GDP, compared to just 0.4% by mid-2021, external resource flows had reduced significantly and real exchange rates were not as overvalued.
New Tilt
Post-1997, the situation in many key EM countries has significantly changed. In the past, EMs were dominated by commodity-producing nations and economies leveraging cheap labour, states Craig Basinger, Chief market strategist at Purpose Investments. “Today’s EM is dominated by Asia, he adds, with a heavy technology tilt.”
Furthermore, South Korea has acceded to developed nation status while the leading EM country, China, has evolved a substantial consumer economy and a respectable technology sector. The investment story now is very different: “We like stocks domestically driven by consumption,” notes Lorraine Tan, Director of Equity Research for Asia for Morningstar. Furthermore, she points out, while the U.S. is tightening on all fronts, “China is expanding its monetary cycle,” adding: “Chinese stocks are already down, so we may not get as great a market selloff, while a recovery could be faster.”
Other EMs, such as Malaysia and Thailand, are still very export-driven, exposing them more to U.S. and Chinese financial tribulations. “But those stock markets are not overvalued by any means, many even trading at discounts because of Covid,” Tan highlights.
Emphasis on Growth
But the general EM context is very different now from what it was in past decades. Much of what happens there hinges on the growth path not only of the U.S. but of China also. Many comments of Aidan Garrib, Head of Global Macro Strategy & Research at PGM Global hinge not so much on general tightening, but on growth perspectives in the U.S. and in China. “With China slowing down, and the U.S., it’s hard to be very optimistic for emerging markets,” he acknowledges. He points to a few potential exceptions that could show some resilience, like Brazil, Chile and the Czech Republic.
Elaborating on Brazil, he notes that one could be more optimistic about it “because it exports industrial products, metal, oil, also food. Its more diversified base will make it more resilient than countries that import commodities, probably even more than oil exporters like Saudi Arabia who must import food at inflating prices.”
Craig Basinger shares the very cautious optimism of Lorraine Tan and Aidan Garrib. He likes the comparatively low valuations and good earnings growth of many developing countries, but he still remains wary of deteriorating financial conditions. “When the world is experiencing tightening financial conditions, EMs tend to suffer more.” But that suffering will be nowhere near what EMs experienced in past decades. “This will not be 1997 all over again, with currency and debt crises,” advises Tan. Perhaps, the fragility of EMs is not much greater than that of developed countries exposed to softening conditions in the U.S. and China.
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