‘Fragile Five’ falls short as tapering leaves more exposed

Forget the “Fragile Five”, the newly minted alliterative grouping of emerging markets at risk. The list of countries exposed as central banks tighten monetary policy is longer than the moniker suggests.

The big worry for investors, as highlighted by the World Bank on Wednesday, is of a repeat of last year’s turmoil in emerging markets after Ben Bernanke, the chairman of the Federal Reserve hinted in May at plans to taper the Fed’s monthly asset purchases. If the adjustment to tapering proves “disorderly”, financial flows to developing countries could decline by as much as 80 per cent for several months, the World Bank warned.

Vulnerable emerging markets

Forex reserves compared

When judged by their perceived ability to repay short-term foreign borrowings the countries particularly exposed to the fallout of tapering are South Africa, Turkey, Brazil, India, Indonesia, Hungary, Chile and Poland, data processed by Schroders and the Financial Times show.

This expands on the “Fragile Five” grouping, a commonplace coinage of the last six months, which incorporates the first five and broadly links vulnerability to current account and fiscal deficits. The expanded list is derived more from fears over short-term debt.

Craig Botham, emerging markets economist at Schroders, says the catchy labels risk blinding investors to broader risks. Market focus is shifting to those countries most reliant on outside finance, particularly those with high short-term refinancing requirements, he said.

“This focus is underpinned by the fear of a ‘sudden stop’, where capital flows halt or even reverse. If this happens, the impact on indebted corporates can be devastating, with knock on effects for banks.”

One metric increasingly adopted to assess emerging market vulnerability compares the size of a country’s foreign exchange reserves to the sum of its short-term external debt and its current account deficit, called the gross external financing requirement (GEFR).

This shows that in the second half of last year, Turkey, South Africa, Chile, India and Indonesia had sufficient reserves to cover around just one year of their respective GEFRs, according to the Schroders’ research. Hungary, Brazil and Poland are less exposed, with reserves to cover around two years of GEFR.

In addition to the eight countries that are vulnerable to tapering, Ukraine, Venezuela and Argentina – which rating agencies rank among the least creditworthy nations – are also seen as exposed. But their weaknesses stem primarily from domestic economic and political uncertainty rather than the effects of tapering.

In its report, the World Bank identified its most likely scenario as a smooth adjustment for emerging markets to tapering that would lead to only a modest reduction in capital inflows. However, it sees long-term interest rates in the world’s largest economies rising by as much as 200 basis points.

The crux for many emerging market borrowers – both sovereign and corporate – is that sharp recent depreciations in their national currencies have inflated the local currency values of their hard currency debt, straining repayment capacities. In some cases, the trend of currency softness has yet to run its course, with the South African rand falling to a five-year low of R10.85 to the US dollar on Tuesday.

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Letter in response to this report:

Chile is a leading global example of resilience