Look beyond doom-laden labels for EM victims

The allure of lumping together emerging markets in groups that hint at doom-laden destinies is strong. But though monikers such as the “fragile five” help simplify analysis, they also blind investors to the key nuances in a dynamic distress landscape.

One source of flux lies with the yardsticks analysts use to judge the vulnerability of emerging markets to the unwinding of central bank stimulus in the developed world. This nuance shows significant variations among countries seen as most at risk.

A test of strength

Countries’ reserves compared with their external financing

“Labels like the ‘fragile five’ are tempting because they divide countries into good versus bad, but over-reliance can mean that you miss important variations within such groups,” says Craig Botham, emerging markets economist at Schroders.

For instance, within the “fragile five” – South Africa, Turkey, Brazil, India and Indonesia – Brazil stands out as comfortably better able to use its foreign currency reserves to withstand any sharp reduction in foreign capital inflows.

According to research by Schroders, Brazil’s foreign exchange reserves could cover well over two years of its gross external financing requirement (GEFR), which is defined as all its short-term foreign debt plus its current account deficit. However, Turkey – potentially the most exposed among the five – could manage slightly less than one year of GEFR with its reserves. South Africa, India, and Indonesia, meanwhile, each has reserves sufficient to cover slightly more than one year of their respective GEFRs, as of mid-2013 (see chart).

By this yardstick, some countries that are not included in the “fragile five” grouping should qualify for this dubious distinction. Chile has slightly more than one year’s reserve cover for its GEFR, while Hungary and Poland each have about two years’ worth of cover, making them more vulnerable than Brazil.

Estimates of foreign reserve cover for GEFR are important because investors are worried that international capital could take fright from those emerging markets regarded as most exposed. The World Bank highlighted this risk on Tuesday, warning that in a “disorderly adjustment scenario”, financial inflows to developing countries could decline by as much as 80 per cent for several months.

“Nearly a quarter of developing countries could experience sudden stops in their access to global capital, substantially increasing the probability of economic and financial instability . . . For some countries, the effects of a rapid adjustment in global interest rates and a pullback in capital flows could trigger a balance of payments or a domestic financial crisis,” the World Bank report said.

The chances of such a “disorderly adjustment” is lower than the World Bank’s “baseline” scenario of much smoother conditions. If this smooth adjustment transpires, it would lead only to a modest retrenchment in emerging market capital inflows, causing long-term interest rates in the world’s largest economies to rise by about 200 basis points, it added. Moody’s, the credit rating agency, holds a similar view.

“There are elements of vulnerability in EM countries that have benefited significantly from (US quantitative easing). But by and large, we think this is a manageable situation,” said Yves Lemay, managing director, sovereigns, at Moody’s. Even those countries with a heavy dependency on foreign financing may not be as vulnerable as their GEFR might suggest.

“The structure of their debt is also important,” says Mr Lemay. “India, which Moody’s rates at Baa3, has an average maturity (on sovereign issues) of nine years and Indonesia, which is rated at Baa3, has an average maturity of 11 years. This helps to limit vulnerability in these countries,” he adds.

In the case of Turkey, which looks highly exposed in terms of foreign exchange cover for its GEFR, Mr Lemay notes that this is mitigated to an extent by the fact that many of the foreign currency borrowers are Turkey’s strongest companies. Hungary, by contrast, is in a bleaker category.

“Hungary, Ba1 with a negative outlook, has a big dependence on external financing. We do expect things will become more challenging there,” says David Staples, managing director, corporates, at Moody’s.

Opinions diverge on Chile, but Neil Shearing, chief emerging markets economist at Capital Economics, sees vulnerabilities related to a worsening trade performance created in part by the government’s decision to boost domestic demand by cutting interest rates.

Some investors, however, see the growing caution surrounding emerging markets as a chance to look for opportunities.

Shamaila Khan, a portfolio manager at AllianceBernstein, created a hypothetical portfolio of more than 100 emerging market bond issuers and found that while 21 per cent of bonds were deemed to be “risky” or “high risk” under conditions of US tapering, some 38 per cent of such companies were classified as “net positive”. Such beneficiaries of US dollar appreciation and resurgent US demand were overwhelmingly emerging market exporters, Ms Khan says.