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07 June 2023

Emerging markets under pressure

By Darren Stubing

Although industrialised countries are mired in economic gloom with still falling growth, the globalisation of the world's financial markets and economy may see emerging markets hit harder and further. Not all emerging markets will be affected to the same degree but those more dependent on capital inflows will be face more problems.

The trend of capital inflows into emerging markets has been dependent on bullish global risk appetite which, in turn, has been driven by the liquidity and growth environment in the developed world. Both of the latter two factors have dried up. Up to mid-2008, capital inflows into important emerging markets increased significantly. Indeed, capital inflows have been one of the most important drivers of growth in emerging markets over the past few years. Countries with low trade and asset market linkages will be less affected. In addition, countries where the recent credit cycle has been more subdued will have less impact from tight credit conditions. Nations with the absence of excesses both in terms of capital expenditure and consumption will be more resilient.

Estimates for growth in emerging markets have been revised downwards and most market estimates are now around the 2.5 per cent level. However, there is more downside risks as the global credit crisis is still some way off bottoming out. Through globalisation and heavy trade flows, the recession has spread quickly, eroding any buffer of support internationally from aggressive policies to stimulate growth.

Emerging markets are facing a number of key risks, including both economic and earnings risks. The deleveraging of Western markets has a rapid impact on emerging markets. The impact on the latter is likely to be wider. This is due to the fact that emerging markets are more highly geared to global growth through trade, capital flows and commodity prices, as Morgan Stanley point out.

Emerging markets are caught in a catch-22 situation. Fiscal stimulus packages, needed to boost growth, are likely to require an important increase in debt financing precisely at a moment when investor appetite for emerging market exposure is falling.

All emerging market regions will be hit. In Asia, the reduction in capital inflows has caused the cost of capital, both equity and debt, for companies to rise. The extent of impact on individual markets from the financial crisis is correlated to their individual dependence on credit growth to increase domestic economic growth and, inter-alia, their current account balances. Countries such as India and Indonesia have seen very rapid credit growth over the past few years and their economies may suffer more through the contraction in financing. With their banking systems experiencing tight liquidity, the balance of payments deficit and foreign exchange outflows have caused an increase in the cost of capital. Their economies will face challenges through domestic financial systems, which in turn will affect their ability to revive quickly. Banking systems will also be hit by rising bad loans as the economy heads southwards.

The sharp slowdown in global growth has resulted in a rapid fall in exports for Asian countries. The weakness in the trade credit market and the erosion of confidence in counterparty exposures has exacerbated the slowdown in demand. Many countries in the region have built large production capacities to feed global export demand. The slowdown in exports is thus likely to cause a weakening in the balance sheets of companies, and corporate investment demand will be hit hard. While many Asian countries, similar to other regions such as the GCC, received the support of private sector construction and real estate investment in 2008, consumption will fall this year as the provision of domestic and international risk capital continues to decrease.

Although most central banks have responded by reducing rates and or injecting liquidity into the system, the action will be negated by the risk aversion contagion from global financial markets. One of the drivers of world growth over the past few years has been China. It also faces significant challenges. Further growth deceleration is expected in the first half of 2009. Chinese growth on the back of exports, investment and construction will weaken, but domestic consumption will aid the economy. Real estate investment in China will see a sharp contraction in 2009, further hitting the economy.

For Russia, Ukraine and other central Asian countries, the weakness in commodity prices will hit economies together with fragility in their banking systems. For Turkey, the main risk lies with external financing, particularly the ability of the private sector to roll over debt. So far the banking sector has rolled over the vast majority of debt.

For the GCC, the main risks are still driven by the price of oil, the real estate sector and the availability of international funding. All three factors will determine the extent of the slowdown in the region.

Latin America will be hit hard by the downturn, particularly the weaker commodity prices. Significant growth over the past few years has been fuelled by global demand and the inflow if foreign capital. As foreign capital inflow has reversed, currencies are vulnerable. Banks will also face the challenge of non-performing loans.

At seven times 12 month forward earnings, emerging market valuations do not appear demanding relative to history. Moreover, having traded at one point over the past 18 months at roughly the same 12-month forward price/earnings ratio as developed markets, they now trade at a 22 per cent discount to developed markets. However, the increasing negative prospects justifies the discount.

Credit contraction, refinancing risk, deleveraging, and high-risk aversion saw emerging market debt issuance fall very sharply in the six months to end 2008. The still weak outlook has seen wider spreads in some new large debt issues from emerging markets but a slight window has opened up at a discount. There have been recent issues from Brazil, the Philippines and Turkey.

Over the past couple of days, the yield spread between emerging market sovereign bonds and US Treasuries deteriorated slightly with a widening of six basis points to 636 basis points, according to the JP Morgan Emerging Markets Bond Index.

The Philippines sold $1.5 billion (Dh5.51bn) worth of 10-year bonds at a spread of 600 basis points over the corresponding US Treasury. Prior to the deal, the existing Philippines issue had a spread over Treasuries of 572 basis points. Turkey's recent $1bn eight-and-a-half-year debt offering had a spread of 501 basis points. Prior to the deal, Turkey's existing issue had a spread over US Treasuries of 485 basis points.

The sharp correction in the asset markets and the tightening in credit conditions are impacting emerging economies. Central banks have taken steps in liquidity assistance and injections into the interbank market to ensure a lower cost of funds to financial institutions. However, it is yet to bear fruit. The recovery in emerging markets assumes improvement in both the availability of risk capital and external demand. This will be some time away.

- The author is a US-based commentator on business issues