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EMERGING MARKETS: Do we have a crisis?

RupeeEmerging market funds have been hit by outflows while currencies such as the Indian rupee have plummeted in value. Is this the start of a crisis or, as emerging market investors say, merely an adjustment? George Mitton reports.

Now is a tough time to be an emerging market investor. Your correspondent knows this only too well, having invested in an emerging market equity fund from one of the big providers in March of this year. At time of writing the fund was down nearly 15%. This is proof, if ever it were needed, that the guidance of investment journalists should be treated with scepticism.

Emerging market equities have taken a particular battering in the last few weeks. Data from S&P Dow Jones Indices shows that combined emerging market equity indices declined 3% in August, pushing their year-to-date decline to more than 11%.

In August alone, the S&P index for Indonesia fell more than 15%, the worst-performing market in the world that month, while Turkey’s index lost nearly 14% and India’s nearly 12%.

The equity falls have come hand in hand with sharp declines in currency values, with the Indian rupee, for instance, falling to an all-time low against the dollar. Is there worse to come? Are we seeing beginnings of an emerging market crisis along the lines of the Asian crisis of 1997?

Emerging market specialists would have us believe not. This is an adjustment, they say, and at least some of the worst-hit countries have an opportunity to emerge stronger from the debacle. Your correspondent hopes they are right.

Most analysts say the trigger for the recent run on emerging markets were statements from the US Federal Reserve to indicate that quantitative easing will begin to be wound down this year.

No one is entirely sure how the end of quantitative easing will affect global markets, and amid this uncertainty, investors have been pulling out of asset classes viewed as speculative. Emerging markets have been singled out as a risky trade.

In some cases, scepticism about emerging markets is justified. Widening current account deficits in countries such as India and Indonesia – the third and fifth-largest economies in Asia – are unsettling. In both countries, central banks have tightened monetary policy, causing growth to slow.

However, many investors believe it is unfair to tarnish all emerging markets by the same brush. They would add that talk of a rerun of the 1997 Asian crisis is overblown.

“The situation for emerging markets is different than in 1997,” says Didier Saint-Georges, member of the investment committee at Carmignac Gestion. “Then, foreign credit fuelled growth. Defence of currencies failed, all the more because central banks lacked reserves. Now, the currencies are floating and acting as shock absorbers, and the banks have more reserves.

“This flexibility suggests we are seeing more of an adjustment than a crisis.”

The power of central banks in emerging markets to influence their economies is felt to be particularly important by emerging market fund managers.

According to Jan Dehn, head of research at emerging market investment firm Ashmore, emerging market central banks control $8.7 trillion (€6.6 trillion) of foreign currency reserves, 80% of the world total. China alone controls $3.5 trillion of currency reserves, he says.

These reserves far outweigh emerging markets’ short-term debt obligations, he says. In Asia, the ratio of reserves to short-term dollar foreign exchange obligations is 3.7, he says, whereas in 1997, external obligations were 2.1 times larger than reserves.

“The capacity of emerging markets central banks to intervene is considerable,” says Dehn.

In addition, central banks in Asia are working more closely together to manage their collective interests, he says.

“Asian central banks have in the past pooled their resources and supported one another with swap lines,” he adds. “We suspect plans are already afoot to renew, enlarge, and widen the network of swap lines between Asian central banks, not least because Asian financial markets are far more integrated today than they were in the 1990s.”

Dehn says emerging market central banks have intervened relatively little in the current turmoil, and suggests some of the banks actually welcome lower currencies, which make exports more competitive.

“But there is a limit to how far central banks will let currencies fall,” he adds. “They cannot sacrifice price stability, or risk materially higher long-term government bond yields. We see signs that currencies are now reaching the point where central banks become more decisive.”

Some would dispute whether Asian central banks have barely intervened, however. In June, China and Japan accounted for almost all of a record $40 billion of net foreign selling of US Treasuries. In July, the Indonesian central bank sold more than 5% of its foreign exchange reserves to shore up the rupiah.

The foreign reserves of emerging market central banks vary hugely. While China has $3.5 trillion, the Indonesian central bank had just $93 billion as of July. Asian central banks may in general be better prepared for a crisis than in 1997, but there are big differences in firepower between them.

Currency depreciation can lead to opportunities for canny investors.

Manish Bhatia, manager of the Schroder ISF Indian Equities Fund, says IT companies and pharmaceuticals firms in India are in an enviable position. Firms in each sector gain most of their revenues offshore, largely in dollars, while most of their costs are paid in rupees to staff and suppliers in India.

“Dollar revenues, Indian costs, that’s a great combination for a company in this environment,” he says.

Producers of iron ore are also in a good position. Iron ore is priced internationally, but like the IT and pharmaceuticals firms, the costs for Indian producers are all in rupees. If investors are selective, they could make some good trades.

However, the value of these opportunities is diminished by the much greater difficulties the Indian economy will face in the coming months. Many other Indian firms will be hurt badly by the weak rupee. Car makers, for instance, will find themselves paying more for steel, which is priced internationally. Bhatia expects these producers to pass on the costs to the consumer.

“For the economy in general, a depreciating currency is never a good thing. The country is getting poorer compared to the rest of the world. Your purchasing power is reducing. I worry the rupee depreciation could lead to higher inflation. The costs of imported goods will increase.”

Bhatia says the Indian central bank has less room to manoeuvre than its counterpart in China. India’s foreign reserves are about $270 billion, he says, which amounts to a little over six months of import cover.

If the markets see India’s central bank spending its reserves to shore up the rupee, investors may panic that India will run out of dollars to meet its import requirements.

“It looks like the next six to 12 months will be a period of weakness for the Indian economy,” says Bhatia.

Some investment analysts say the current turmoil in emerging markets is not a reason to give up on the asset class entirely, but is a reason to be more selective about which countries to invest in.

Besides the trouble facing India and Indonesia, there are deep concerns about Argentina and Venezuela, which are both considered at risk of defaulting on their loans.

In contrast, the S&P China index returned nearly 3% in August, bucking the trend in a month when many emerging market stock indices went negative. Another Asian country, Taiwan, has produced a positive return year-to-date.

Investors who stay committed to emerging markets this year would be advised to pick and choose.

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