Article originally published by Hermes Investment Management on 28 January 2019.
Emerging markets contended with a challenging backdrop in 2018, amid less accommodative global financial conditions, slowing economic growth in China and fraught US-China trade relations. But emerging market economies are better placed to weather negative shocks than in the past, argues Silvia Dall’Angelo, Senior Economist at Hermes Investment Management. In her latest Ahead of the Curve, she assesses how improved financial resilience, robust policies and few new tailwinds could support a brighter 2019 across emerging markets.
2019: a turning point for emerging markets?
Economic stress is likely to remain contained to emerging-market countries with weak fundamentals or political instability. Furthermore, on a relative basis, some emerging-market economies may be well-placed to benefit from a small number of global macro tailwinds, including:
- A dovish turn in the narrative from the Fed in 2019: the Fed’s recent communications have already had a more dovish construct, which has resulted in stabilisation of the US dollar.
- Lower oil prices: Brent crude has fallen by about 30% in US dollar terms since its October highs, providing relief for oil-importing countries.
- Central bank-policy response is likely to remain proactive and although vulnerabilities exist, emerging-market economies appear more resilient than they were in the past.
Stress vs. resilience
Emerging markets are generally open economies that rely heavily on external trade and financing. In addition, Asian economies usually have close ties with China.
Silvia Dall’Angelo, Senior Economist, Hermes Investment Management, said: “Recent emerging market stress has been confined to countries characterised by weak fundamentals and political instability, such as Turkey, Argentina and South Africa. This suggests that emerging market sovereigns should no longer be considered a single asset class but grouped together based on different credit qualities and their ability to pay based on their external debt obligations.”
Today, emerging market economies seem better placed to weather negative shocks, having learnt lessons from previous crises: financial systems are more resilient and better policies have been implemented. For the most part, external debt ratios in emerging market economies have stabilised since the onset of the global financial crisis, while current account deficits are less pronounced. What’s more, there are fewer currency pegs, the majority of central banks are independent, and for the most part, monetary policies have been tightened to shore up local currencies and curb inflationary pressures.
These drivers should limit contagion risk going forward, but that’s not to say that in a world characterised by slower growth and increased protectionist threats, weak links do not exist – they do. For example, non-commodity-exporting sovereigns with a high exposure to short-term US dollar-denominated debt and foreign saving needs will remain vulnerable.
The role of the US dollar
The reliance on US dollar-denominated credit is another element of vulnerability for emerging markets economies. The US dollar played a prominent role in the Asian financial crisis, as it was the main currency in which most cross-border claims of Asian countries were denominated. In the early 2000s, US dollar-denominated borrowings to emerging markets began to accelerate again, touching new highs just before the onset of the global financial crisis.
In the current cycle, there are a number of factors mitigating financial stability risks from large stocks of US dollar-denominated debt. First, US dollar-denominated debt securities, which are issued by emerging-market borrowers, have longer maturities than in the previous cycle. That means they are less vulnerable to run and rollover risks. However, they are exposed to market risk: bond prices are more sensitive to yield changes, reflecting longer durations.
Second, and more importantly, “emerging markets hold substantial foreign exchange reserves. Today, the import cover of emerging market sovereigns – that is, how many months of current imports are covered by a country’s foreign exchange reserves – has improved compared to the run-up to the global financial crisis,” Dall’Angelo continued.
Cross-border bank lending to emerging markets
Cross-border lending data1 from the BIS provides an in-depth insight into the evolution of financial imbalances in emerging markets. The build-up of financial vulnerabilities is reflected in the procyclicality and slow-moving nature of balance sheet aggregates, especially for the banking sector2. Indeed, it is easier to capture lending trends by focusing on the cross-border component of a bank’s balance sheet, where there is typically a close link between cross-border credit and domestic credit, with the former tending to amplify moves in the latter.
Source: The Bank for International Statistics and Reuters Datastream as at December 2018.
Dall’Angelo, said: “Lending to emerging-market economies has radically evolved over the past four decades; the market has grown from less than $350bn at the end of 1980 to almost $4tn by end of 20173. There have also been significant shifts among regions; in the 1980s, the biggest emerging-market economy borrowers could be found in Latin America, while today, lending to emerging Asia accounts for roughly half of all bank lending to emerging-market economies4”.
In addition, the 12-quarter growth rate of the ratio of cross-border claims on a given country to its GDP is a useful early indicator of systemic banking crises. This information on growth rates, coupled with information on levels (cross-border claims/GDP), provides a reliable indication of whether – and where – vulnerabilities are building up in the system. The lending picture (in terms of levels and growth rates), as depicted in Chart 5a and 5b, shows that financial-stability risks are lower in Q2 2018 than they were in Q4 2007.
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