Emerging Markets Risks
(January 12, 2012)
Dear Subscribers and Readers,
Instead of the end of January, we have shifted our MarketThoughts.com end date to the end of February, as there are so many enduring topics we still want to cover! But don't worry—I have the MarketThoughts.com mailing list and will email you my “market thoughts” on an ad hoc basis going forward. Please let me know if you do not want to be on my personal mailing list.
Over the last several months, we have discussed risks that have recently popped up in emerging market countries due to declining US$ liquidity. One such risk is the new lows in the Indian Rupee—which the recent US$15 billion BOJ swap line has partly alleviated. Other risks involve Hungary and Turkey—the former still awaiting IMF loan approval; while the latter is suffering because of a disastrous central bank policy starting in December 2010. On the surface, there is little risk of a “blow-up” in EM, given robust economic growth, elevated commodity prices, and stable real estate prices. Indeed, credit growth in EM countries has risen back to pre-crisis (late 2007) levels—while DM credit growth remains stagnant—as shown in the following chart (courtesy of Goldman Sachs):
Over the next 3 to 6 months, I see little risk to emerging market countries, especially given the Bank of England's commitment to additional QE (likely an additional 125 billion pounds of liquidity starting in February), the ECB's openness to actual QE, the beginning of a looser monetary policy in China, and the resilience of the US economy. The $64 trillion question(s) is thus: Is the current growth in EM countries sustainable on a stand-alone basis? If not, will the resilient US economy provide a pillar of support for EM countries? How about Chinese economic growth? Is systemic risk in the Euro Zone a concern? Again, the next 3 to 6 months will likely remain a benign period; however, we remain concerned about the second half of this year for EM countries, especially if U.S. and Chinese economic growth surprises on the downside (note that global US$ liquidity is still deteriorating).
By the second half of this year, I feel every investor should start tracking EM risks—on a country-by-country basis—more closely. More specifically, higher-risk countries with high debt-to-GDP ratios, current account deficits, and declining foreign currency reserves. Interestingly, Turkish credit growth last year remained red hot, despite its ongoing current account deficit and currency concerns.
Over the last five years, the credit/GDP ratio of Turkey has grown by more than 20%--which is significantly higher than that in its past economic expansion. For Turkish investors, the question is whether its regulators/banks have been sufficiently prudent in its lending (likely not), given that the country has never experienced such high credit growth.
Interestingly, three other EM countries (if we include Hong Kong as an EM and separate country) have experienced higher growth in their credit/GDP ratios over the last five years, those being Hong Kong (>60%!), Poland, and Brazil. At the end of 2011, Hong Kong's private debt to GDP ratio is a whopping 200%. However, it is important to note that the Hong Kong Monetary Authority possesses foreign currency reserves in excess of 120% of GDP. Combined with Chinese backing, there is no danger of a currency crisis in Hong Kong. The HKMA can always sustain its US$ peg. The question is: Do they want to? It is no accident that Hong Kong's debt-to-GDP ratio has gone through the roof over the last five years as it lowered its policy rate to match that of the Federal Reserve, despite robust domestic growth. For now, as long as commodity prices remain stable, both Poland (which is trying to bring a substantial amount of shale gas to Western European markets) and Brazil look safe. Again, investors will need to reevaluate as we approach the second half of 2012.
Henry To, CFA, CAIA