EM selloff - party like its (not) 1999

By bne IntelliNews January 31, 2014

Ben Aris in Moscow -

Emerging markets (EM) have been selling off hard in the last few weeks and several currencies tumbled to a degree that forced central banks to hike rates dramatically. But a note issued by Goldman Sachs this week says keep calm, don't panic: this is not the 1990s. Things have changed a lot since the 1990s when the Asian crisis in 1997 quickly spread to Russia (after demand for raw materials and oil sank), causing the Russian meltdown.

This time round, thanks to the fact that the emerging markets have done a lot of emerging in the last decade, these economies are a lot less vulnerable to sharp changes in things like commodity prices. "The big problem for many EM economies [in the 1990s] came because fixed exchange rates had encouraged significant borrowing in foreign currency, much of it at short maturities," Dominic Wilson and the macroeconomic team at Goldman Sachs said in a note entitled, "What happens in EM (mostly) stays in EM". "Without adequate reserves to maintain those currency pegs, large depreciations followed. Currency weakness weakened balance sheets, hurting the domestic economy and leading to sharp growth slowdowns and rapid current account reversals."

However, over the last decade as these economies grew and the countries in question built up reserves, most have transitioned to either freely traded currencies, or in the case of a country like Russia, virtually free currency regimes. Flexible currency regimes mean an economy can absorb external shocks much more easily by letting its currency devalue. A falling currency is still not fun, but central banks have the option of fighting back by hiking interest rates - which is exactly what half a dozen central banks have done in the last week. In Turkey's case, which was hit harder than most, the central bank almost doubled rates overnight.

Another problem from the 1990s which is less evident now is that the fixed exchange rates made lending to EM very profitable and so many of the countries loaded up on foreign debt, usually with short maturities. However, having been burnt once, in the naughties EM governments began borrowing much less, preferring to tap their domestic saving markets or making use of much more sophisticated domestic capital markets, reducing their vulnerability to external shocks. "External debt and foreign currency borrowing have generally been much lower; and reserve levels are in many places substantially higher," Goldman said in its note. "As a result, currency weakness itself is unlikely to be as sharply disruptive as it was in the late 1990s."

This is not to say that EM are not connected to the international capital markets and global volatility does not have an impact - it does. With the global low interest rate environment there has been a bum rush into the high yielding EM bonds, which reached a crescendo in 2013. These bond investors may pull out if they expect a period of sustained volatility, which would be painful.

And commentators are expecting more volatility, as at root of the current turbulence is the decision by the US Federal Reserve to start winding down its quantitative easing programme. The trouble is much of the US' "free money" from the programme has found its way into EM markets, so reducing the amount of money it is printing is going to have various effects on the EM markets. "And rapid currency weakness may raise inflation risks. Central banks can respond by hiking rates (as Turkey, India, Brazil and South Africa have all done recently) but this will slow growth and could expose vulnerabilities in the banking system, so may cause different problems," says Goldman.

But there is a silver lining too. Economic growth was unexpectedly weak in all the countries of Central and Eastern Europe in 2013 and falling currencies will stymie increasingly expensive imports, encourage import substitution, boost profits of exporters that are paid in hard currency but count their costs in local currency (raw material exporting countries in particular), and will stimulate investment as a result. "We would highlight that EM currency weakness in and of itself is probably less of a problem - and more part of the solution - than it has been in many past episodes," says Goldman.

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