EM economies have not bottomed out yet – the worst is still to come!
Mixed Signals on EM Economic Performance Mainstream economists are of the opinion that the emerging market economies and emerging market currencies have not seen the worst of it yet. EM currencies have been particularly hard-hit with the slowdown in the Chinese economy, followed by plunging commodity prices around the world. However, on 1 October 2015 – the official start of Q4 2015 – conditions appear to be turning for the better. Not only have stocks gained the most in 1 week, but currencies too have been performing better than expected. The accepted gauge of the emerging market sentiment – the MSCI index rallied by 0.8% and the Asia benchmark gained 1%. These are encouraging trends in an otherwise downtrodden EM sector. Many economic analysts believe that the stresses caused by weakness in China have had a particularly harsh impact on emerging market currencies. Extensive selloffs characterized EM bourses from South Africa to Nigeria, Egypt, Turkey, Brazil, Venezuela, Russia, India and China of late. One of the hardest hit EM economies was Brazil, but that country is also in the process of rectifying its economic quagmire.
What is facilitating the collapse of EM currencies?
The answer to this question is multi-pronged. For starters, structural weakness in the Chinese equities markets has hit emerging market countries particularly hard. Slowing demand from China – the world's second-largest economy – means that production levels in emerging market countries are down. That leads to declining revenues, decreasing profits and layoffs. Commodities prices are feeling the pressure and are plunging at a rate of knots. With less demand for the exports of these countries, the currencies of these countries are also taking a hit. But there is an even more important component to consider – the strength of the US dollar. Wall Street has also been impacted by China weakness, but the 3% devaluation of the CNY has hardly been substantial enough to cause a meltdown of US equities. Instead, what we see is structural strength in the US market with low unemployment, better-than-expected consumer confidence and positive GDP growth. That the Fed has decided to hold off on a rate hike for now is only causing additional anxiety with emerging market currencies. Indeed, Janet Yellen intimated that she would likely raise short-term interest rates before the end of the year. That is the harbinger of doom for emerging market currencies. When the Fed raises rates, the dollar becomes more valuable and EM currencies will be traded for dollars on the currency markets.
Disturbing Trend Taking Place with Emerging Market Capital Flows
It has been reported by the Institute of International Finance (IIF) that negative capital flows will be experienced in emerging market countries for the first time since 1988, in 2015. And the factor that is fueling this is the prospect of a rate hike before the end of the year in the US. During the course of 2014 emerging markets enjoyed capital inflows of $32 billion, with net outflows exceeding $540 billion. There are several reasons why capital flight is so extensive with respect to EM countries. One of them is the uncertainty that investors perceive in this sector of the market. That is compounded by real concerns vis-a-vis China weakness. And the situation does not bode well when we project into 2016 either. Next year, only modest capital inflows are expected, with risk remaining high as a result of a depreciating Chinese yuan. Two of the most vulnerable countries in the emerging market sector include Turkey and Brazil. Both of these nations are dogged by political instability, severe forex liabilities and large current-account deficits. Foreign currency reserves will continue to be depleted as these countries sell dollars, euros and sterling to prop up the local currencies. Analysts at the IIF have forecast outflows of $1,000 billion dollars and inflows of $548 billion. This would significantly impact upon the foreign currency holdings of central banks in EM countries.
Servicing Higher Levels of Corporate Debt
Further pressure is being applied on EM asset prices as a result of increased levels of corporate debt. With plunging revenues and profits (owing to commodity price weakness) we are seeing companies like Glencore (LONDON:GLEN) struggling to assuage investors. This is especially true where mining companies are selling corporate debt worth billions of dollars, with no safeguards in place to make good on the repayments. However in the case of Glencore, there are many asset holdings that the company can divest from in order to generate liquidity. The company is the worst performing operator on the FTSE 100 index for the year. Not only did the stock plummet by 30% on Monday, 28 September, further declines are forecast unless commodities prices start improving. The problem with Glencore is that it has exceptionally high debt. However the company has been hard at work in trying to reduce its overall level of debt by adopting a $10 billion dipped reduction strategy. As part of its divestiture programme, Glencore will reduce less profitable trading activities and is prepared to liquidate asset holdings and inventories if necessary.
EM Countries and the MSCI Emerging Markets Index
The dilemma comes in when one considers the cross currency exchange rates of EM currencies vis-a-vis the US dollar. Should the dollar appreciate relative to EM currencies, the debt which is dollar-denominated will be much more expensive for these emerging market countries to service. This is compounded by negative capital flows and declining investor confidence in EM countries. According to the MSCI index, the net returns as at August 31, 2015 for emerging markets for the month were -9.04 percent and -12.85% for the year to date. In terms of country weights in the MSCI index, China comprises 22.9%, South Korea comprises 15.59%, Taiwan 13.07%, India 8.82%, South Africa 7.8% and other countries 31.75%.