EM Contagion: Who’s Next??!!

10 August 2018

In the wake of the turmoil in Turkey, markets are considering which Emerging Market currencies potentially could be vulnerable if a broader EM contagion develops.  A couple of my favourite Charts may provide some clues.

What has provoked the dramatic run on the Turkish lira?  Chart 1 illustrates the Turkish currency  was not especially overvalued when the latest phase of the crisis unfolded. However,  Chart 2 compares EM nations’ external borrowing requirements — defined as the sum of short-term external borrowing, current account deficit, minus foreign direct investment inflows — compared to international reserves at the central bank — rainy day money! Turkey’s recent addiction to short-term external borrowing (both by banks and especially corporations), rather than an especially large trade imbalance, has left the nation especially vulnerable to shifts in market perceptions of sovereign risk. Under normal circumstances, foreign lenders routinely roll over short-term loans.  But, when the credibility of the nation’s economic policymaking is questioned, external lenders become more risk averse.  This is exactly what is happening in Turkey. This will continue until some sense of policy credibility is restored.

So, in assessing which EM countries might be particularly vulnerable, focus on the following factors. Large short-term external liabilities, bloated current accounts, and low stockpiles of foreign reserves at the central bank leave countries vulnerable to shifts in investors’ risk appetite.  Is the FX overvalued?  Finally, is the current policy course appropriate and sustainable?

Strategic Thoughts
  • Turkey is the extreme case within the EM universe: external vulnerability is by far the highest, and policy credibility the lowest. I expect a full-blown EM FX crisis will be avoided.
  • Russia’s external situation is healthy.  However, its policy credibility is low.  The imposition of sanctions following the invasion of Crimea hit the economy hard. If a hardening of the sanctions regime chokes off Russia’s tepid economic recovery, the RUB could experience a decline similar to the earlier episode.
  • South Africa’s vulnerability stems from its relatively low-level of international reserves, along with rising current account deficit and a poor track record in attracting FDI.  FX weakness could provoke the SARB to raise interest rates earlier than expected.
  • Mexico’s external borrowing needs are elevated, but the MXN is already extremely undervalued reflecting NAFTA worries.
  • In Brazil, BRL is not overvalued nor are external financing needs especially problematic.  However, fiscal policy credibility could come into question in the run-up to the elections.
  • In Asia, the Indian rupee appears overvalued and the nation’s external borrowing need (while manageable) is elevated compared to other countries in the region.
  • Keep an eye on HUF and PLN.