Midlife Crisis in Emerging Markets
31st January 2014
Argentina is an intersting case study of the kind of turmoil that emerging markets are going through following the start of the Fed’s QE “tapering”, says Jagannadham Thunuguntla, Chief Strategist, SMC Global Securities Limited
The performance of emerging markets over the next few months will play a big role in determining the global fund allocation plans of global investors. Most of these economies have been growing much faster than the mature economies over the last two decades or so. But now they seem to be facing a mid-life crisis in the aftermath of the global financial crisis (GFC) of 2008. In many cases, growth rates have fallen and currencies have weakened vis-a-vis the dollar and other major currencies despite the stimulus policies of their own governments as well as that of the world’s largest single-country economy the US.
In fact, since the middle of 2013, ever since the US Fed announced that it was planning to “taper” off its third Quantitative Easing (QE3) programme, there has been some kind of a tectonic shift in the perception of investors with regard to the emerging markets that was further aggravated after the first reduction in the US government’s securities purchases in December last. Investors are now keenly waiting for fresh signals about “tapering” that would be sent out by the Fed on Wednesday after Ben Bernanke’s last meeting as the chairman of the FOSC.
Against this backdrop, Argentina provides an interesting case study for taking a peek at the various dynamics at play.
The Decline and Fall of the Argentine Peso
Argentina, one of the most literate nations among all the 24 emerging markets, has a long tradition of international business presence as it has always been an open economy quite unlike many of the other emerging markets. Even then the country has faced its fair share of economic crisis.
The recent devaluation in the Argentinian peso has, however, stoked fresh fears of another financial meltdown perhaps as severe as the one that the nation had face just a little more than a decade ago. The sharp mark down in the currency, the most since Argentina’s 2002 financial crisis, has raised apprehensions that inflation could speed up even further. Some estimates suggest that the inflation in the country is now a little above 25%, one of the world’s highest “unofficial” inflation rates, and this has been continuously decreasing the value of its currency.
Actually, the kind of financial mismanagement that had led to the crisis in 2002 seems to have reared its ugly head once again and has now pushed the economy to the edge of a balance of payments crisis. This is despite the fact that Argentina witnessed a wave of Foreign Direct Investment (FDI) between 2004 and 2008 with investments primarily in the manufacturing, natural resources and new technology sectors. Since 2009, however, FDI has been shrinking due to the global economic crisis in line with the rest of the world. Over the last three years, the country’s policy makers have been trying to cushion the falling peso by using its foreign exchange reserves to bring it down to $25 billion dollars in November 2013 from $47 billion in March, 2011.
Now the question that investors are asking is – which is likely to occur first, a currency crisis or a series of bond holdouts? Of course, only time will tell whether the players who have withdrawn their investments and have left the country with a bagfull of cash will once again come back. Ever since Argentina defaulted on $100 billion in debt during the 2001-02 crisis, the country has been cut off from the global capital markets as most investors began to consider it as one of the most risky places to do business.
What Is Behind The Decline?
One may wonder what is actually happening? This devaluation seems to be an attempt to preempt the kind of depreciation that other emerging market currencies, such as Turkey’s lira and India’s rupee, have suffered 2013 on the back of the expectation that the policy makers of the US, England and Japan will pull back on shoring up their own economies. While Argentina has taken the devaluation route, Turkey has been forced to sharply hike its interest rate to stem plummeting government bonds and a further slide in the Lira vis-a-vis the dollar which plunged to record lows . In the latest monetary policy review, India too raised its base rate despite some easing of inflationary pressure and the crying need to boost growth.
The ongoing pulling back of the stimulus program by the Fed has led to higher bond yields in the developed markets and the dollar has strengthened as well. However, this financial turmoil in Argentina may act like a catalyst for growing risk aversion at a time when investors are overstrung about tapering monetary stimulus from the US and slower economic growth in China, which is one of the most important emerging economies. One cannot deny that the big story of 2014 in the emerging world is the black cloud of debt that is looming over China, which is also a member of the BRICS (Brazil, Russia, India, China and South Africa) nations. In fact, at present almost all the BRICS (Brazil, Russia, India, China and South Africa) economies are in the middle of a midlife crisis due to a combination of factors such as fallout of the US Fed tapering and ineffective governments.
With dwindling foreign-exchange reserves and the spectacular weakening of its currency, Argentina is sure to undermine the confidence of emerging market players. Also the political risks in countries such as Ukraine, Turkey and Thailand are adding to the disomfort of emerging market investors who are already affected by Argentina’s foreign exchange policy and the threat of it breaching international contracts.
Fighting the Fed Tapering
The stimulus package of the US Federal Reserve in the form of three rounds of Quantitative Easing (QE) to fight the consequences of the 2008 liquidity crisis has led to free flowing liquidity into emerging markets. This has elevated asset prices, capital markets and currencies of almost all the emerging markets.
However, the Fed’s decision in 2013 to start cutting back its Quantitative Easing (QE3) programme has led to a quick reality check in most of the emerging markets with sudden retracement of foreign flows from the bonds and equities of emerging markets which in turn has resulted in crash landing of their currencies. Even the Russian rouble has fallen to a record low.
This sudden awakening has forced emerging markets to adopt fire-fighting measures ranging from liquidity infusions, unexpected and unscheduled hikes in interest rates and verbal interventions. During the last week, the central bankers of emerging markets ranging from South Africa, Brazil, India and Turkey unexpectedly increased their benchmark interest rates, that tightened their monetary policies in a bid to bolster their currencies.
In this regard, Argentina went one step ahead and adopted the measure of devaluation of its currency. Argentina has decided to allow its currency to weaken to 8 pesos per dollar to preserve foreign reserves that have fallen to a seven-year low. This measure of devaluation may temporarily ease the pressure on foreign currency reserves of Argentina, but the government has to adopt many more radical measures to address the underlying causes of foreign fund outflows, control inflation and bring back investor confidence.
Despite all these fire fighting measures, the currencies of most of these emerging markets still appear to be vulnerable and susceptible to an expected complete tapering of the Fed’s QE3 programme.
Conclusion
Currency devaluation, coupled with rising inflation have created an uncertain outlook about the Argentine economy. So, there is a sense of huge discomfort amongst Argentinians and their financial institutions. No doubt, Argentina benefited from the global wave of Foreign Direct Investments (FDI) between 2004 and 2008 but the situation is far different now.
The key worry of the big global investors is the extent to which the developments in Argentina as well as other emerging markets will force them to change their global capital allocation programme which in turn will impact the investment plans of all players big or small.
Read more Articles by Jagannadham Thunuguntla