Since Turkey began to melt down in earnest starting about two weeks ago, the focus of market participants when it comes to spillover risk to other developing economies has generally centered around “classic” contagion via currency depreciation and the exposure of balance of payment risks.
That’s understandable given similarities between Turkey’s situation and some other “at-risk” EM high-yielders like, for instance, South Africa. The rand had a rather rough go of it this week amid a negative Moody’s statement (that suggested the country’s fiscal deficit will come in at ~ 4% of GDP in 2018-19, higher than the 3.6% government projection), weakness in commodities and also the plunge in Naspers following Tencent’s second quarter flop.
This is all playing out against a backdrop of Fed tightening and, more generally, the unwind of the post-crisis DM monetary policy regime that’s catalyzed massive inflows into emerging market assets from investors searching for any semblance of yield. The reversal of that dynamic has the potential to effectively make a bad situation worse or, more simply, to turn a “classic” EM crisis into a kind of amalgamation, a component of which is a possible VaR shock – or at least that’s the opinion of Nomura.
In a note dated August 13, the bank’s analysts begin by breaking down the fundamental picture using what they call “a simple scorecard approach”. Here’s Nomura:
To arrive at an overall summary measure for each country, we first convert the values for vulnerability indicators into standardized Z-scores. We then take a weighted average of the six Z-scores for each country (we assign higher weightings to the current account and FX reserves) to arrive at our overall summary statistic (final column in Figure 1). The higher the Z-score, the larger the BOP risk.
They also provide the following handy color-coded word cloud and as the bank writes, describing their visual, “BOP risks are highest in EEMEA and, with the exception of Hong Kong, relatively low in Asian countries, a major change from 1997.”
(Nomura)
But as alluded to above, the more interesting sections of the bank’s analysis revolve around the potential for the tightening of DM monetary policy, ongoing trade frictions and a continued deceleration in Chinese economic activity to catalyze a VaR shock in Asia, as the combined effect of those three factors forces selling in order to fund redemptions amid investor angst.
“In Asia, there may be some short-term BOP-related contagion in [Indonesia, India and the Philippines] but from a fundamental standpoint, we believe the bigger vulnerability for Asia in coming months stems from domestic credit stress and evaporating market liquidity, not balance of payments or currency pressures, and the economies most exposed are China, Korea, Taiwan, Hong Kong, Singapore and Malaysia,” the bank writes.
After explaining that in their view, pressure from the Trump administration’s protectionist policies, G4 quantitative tightening and slowing Asian growth is likely to “intensify” going forward, Nomura details what they think is the real risk for the region. To wit, from the note:
A VaR shock, as experienced in previous instances of specific EM stress is possilble. The concerns emanate from several fronts, including still relatively large positioning from real money in Turkey (tracking the JPM EMGBI) for which we have seen investors overweight on a geographical basis in eight of the past 12 months to June 2018. This is similar in other parts of EM, with overweights in Asia (except THB), LatAm (except COP) and EEMEA (except PLN; Figure 3). Like the Russia-led VaR shock, the contagion effect is driven by the need of real money investors to sell their holdings (even those with strong local fundamental stories) in other markets to fund redemptions, as indicated by discussions with EM real money investors, as well as by the strong historical relationship between global EM and specific EEMEA/LatAm/Asia dedicated funds’ net flow data.
Needless to say, years of accommodative DM monetary policy have pushed investors into EM and as Nomura goes on to detail, July data shows the following high level of foreign ownership in Asia EM assets:
- foreign bond ownership in Indonesia at USD58.2bn (37.7% of outstanding);
- in Malaysia at USD42.8bn (25.4% of outstanding);
- foreign equity ownership in Korea at USD542bn (32.8% of market cap) and Taiwan at USD465n (38.2% of market cap)
In other words, although emerging Asia may be in better shape from a fundamental standpoint than during the 1997 crisis, it could very well be vulnerable to an acute liquidity crunch if inflows slam into reverse.
“While BOP positions in emerging Asia are relatively healthy, the region has become increasingly vulnerable to credit defaults and financial stress, as almost a full decade of low interest rates and strong capital inflows has misallocated resources (e.g., to real estate) and fueled a large build-up of debt”, Nomura warns. If investors start to reassess emerging market assets with an eye towards mitigating risks as opposed to chasing yield, well then babies will be thrown out with bathwater, as asset managers are forced to sell.
Additionally, you’re reminded that part and parcel of Fed tightening is more attractive yields on USD cash and cash equivalents. If you can get past the negative real yield (which is an absurd thing to say, but c’est la vie, that’s a sign of the times), you might start to wonder whether it makes sense to stay allocated to some of these carry trades that are becoming less and less viable by the day.
“Rising vol and meagre YTD returns are suddenly being complemented by renewed awareness of how single-name blow-ups can at a stroke wipe out months of carry”, Citi’s Matt King writes, in his latest missive, before reminding you that the “sucking sound” you’re hearing “is the irresistible lure of 2.5% on $ cash — risk-free — pulling money from your asset class.”
If you’re still long EM that … well … that “sucks”.
