Will the next market crisis turn into a contagion?


IN today’s scenario, one of our key focuses is the US Fed and European Central Bank (ECB) – both fiddling with their monetary policy. It represents a wind of change in global markets. From a tailwind due to the massive bond-buying programme that effectively supported risky assets, the tide has changed to become a headwind.

Easy money is disappearing from markets as global central banks turn the spigot on accommodative monetary policy. We now expect the Fed to embark on a total of four rate hikes in 2018, with the third hike in September and the fourth in December, each by 25 basis points (bps) to settle at 2.25%–2.50%. We believe the Fed will continue with another two rate hikes in 2019 to stabilise at 2.75%–3%.

Meanwhile, we reiterate our view that the ECB will halt its quantitative easing programme by end-2018, putting an end to the stimulative policy which went into effect early 2015.

We expect the tapering from €30bil to €15bil in 4Q18 before it stops. Potential repricing of the interest rates will start sometime in 2019.

Our other key focus is the trade war. It is expected to have a bigger impact on the financial markets than the real economy. Arguably, our focus is on the US-China trade spat which is more sensitive for Asia than the trade war between US and the others. We found a 10% hike in import tariffs on China, Europe, and the US could lower global GDP by 0.8% and global trade by 4%. It will reverse the recent synchronised global growth.

In the meantime, there are two pressing questions in our mind on emerging market (EM) countries, namely:

Whether a crack in EM countries will trigger a contagion effect. Much will depend on: their ability to repay US dollar denominated debt; exposure to external financing requirements; and the size of foreign investor pool in domestic-denominated debts. These issues will determine if the EMs’ assets are threatened by the confidence of investors who once felt the region to be comparatively safe.

Are there possibilities for a widespread crisis to be contained from spreading across the EM countries? A contagion can be avoided if we differentiate the vulnerabilities within EM countries with strong fundamentals and otherwise.

In 2013, the phrase “taper tantrum” saw panic selling when the US Fed announced it would begin to reduce its USD billion-bond purchases. Bond prices collapsed and yields skyrocketed. The effects were felt most strongly in EMs, where domestic currencies suffered free falls by the outflows of capital.

A similar pattern seems to have emerged recently. Currencies like the Turkish lira and Argentine peso took a beating. These currencies lost a great deal of their value due to the US Fed rate tightening cycle, the US dollar strengthening and trade war once again forced capital out of the EMs. Both the Argentine peso and Turkish lira fell sharply by 24.1% and 19.1% between February and May.

The issue in Turkey’s economy and currency are more home-made, driven by the fast becoming authoritarian President Erdogan. His lack of economic insight could serve to worsen the problem.

More so with him taking on more responsibilities on the monetary policy. Fears accelerated on the independence and credibility of Turkey’s central bank as Erdogan will completely undermine the central bank.

This will leave the lira with nowhere to hide. Inflation is climbing and is projected around 11.4%, which led the central bank on May 23 to raise interest rates to 16.5% from 13.5% despite Erdogan’s threat to exert his influence on the central bank to prevent rate hikes which exacerbated the lira’s fall. The economy is expected to suffer from rising current account deficit due to a weak currency that will add cost on imports and rising public debt.

In the case of Argentina, it found itself in another financial crisis situation and has sought assistance from the International Monetary Fund (IMF) with a line of credit believed to be around US$30bil. It will be the IMF’s first financial support package for the country since 2003 following a rocky relationship after having defaulted on its foreign debt in 2001.

Like Turkey, Argentina sits on a large current account deficit, rising public debts and skyrocketing prices. Inflation is projected around 20%–25% in 2018. To prevent further capital outflows, the central bank raised the key interest rates from 27.5% to 40%. Besides, the economy requires large financing given the high fiscal deficit and maturing debt.

What is haunting now is the re-emergence of these EM countries’ past economic dilemmas. Despite the peso and lira having plummeted, they have yet to trigger a financial crisis on par with those of past years. Yet, the stage is probably set for a bout of global risk aversion although perceptions are that the issues will be confined to a handful of countries as other EMs may be well adapted to rising US interest rates without creating major upheavals.

Identifying the next crisis

In identifying the next crisis, the focus is on two major issues – currency and debt. We are of the view that EM countries with a huge load of debt can be adversely impacted. Their market access can be disrupted and this can jeopardise their economic activities.

Besides, rollover risks will accelerate when the EM countries require large financing needs, particularly when the maturities are short. The impact will be severe when there is a shift in investors’ sentiment.

Furthermore, risk premium will rise as worries accelerate on the country’s ability or willingness to pay. It will limit their capacity to conduct countercyclical policies, especially during times of financial crisis or unfavourable growth or fiscal shocks.

A shift in global sentiment back to a risk-off environment is on the table as fear picks up. That means there is room for current crises to emerge triggered by debt crisis.

A currency crisis can be defined as a sharp decline of more than 20% of a local currency against the US dollar. There are many reasons for it to happen with unsettling models to predict the timing of currency crises. Thus, we can expect many views on the causes and consequences.

In this case the Exchange Rate Market Pressure Index (ERMPI) was developed with the aim to examine if the EM countries could become vulnerable to and likely lead to a potential currency crisis. Here, the readings from the ERMPI for each local currency vis-à-vis the US dollar is compared against a threshold which is two standard deviations (SDs).

Should the reading of ERMPI breach the second SD, that particular EM’s currency is on “high” risk of heading into a potential currency crisis.

If the reading is between 1 and 2 of the SD, the particular EM country’s currency risk falls into a “moderate” category. And if the reading is less than 1 SD, that EM country’s risk for a currency crisis is low.

Now those EM countries, which have fallen into a “high” risk of potential currency crises are Argentina, Brazil, India, Mexico and the Philippines. Meanwhile, for countries like Malaysia, Thailand and Turkey, they fell into the “medium” risk category. In the meantime, Indonesia, South Africa and Turkey are in the “low” currency risk category.

Debt crises

It is risky to assume that EMs’ financial conditions will continue to remain easy, especially with the differences in interest rate expectations between the US and Europe suggesting the US dollar has become undervalued against the euro and is overdue for a correction. There are also changing financial conditions in EMs. Inflation is poised to turn positive on the whole in EMs although it will continue to fall in some countries.

Possibilities for the EMs to experience strains to deal with the rising cost of US dollar borrowing are brewing. More so with the US dollar foreign-currency debt rising from US$4.5 trillion in 2008 to US$8.3 trillion in 2017.

Countries on the watch list are Argentina, Indonesia, Mexico, Turkey and Philippines given their high foreign debt exposure as a percentage of GDP

At the same time, focus is also on EM countries maturities exposed to US dollar borrowings that need to be repaid or refinanced in 2019.

There is a growing risk for countries like Argentina, Turkey, Brazil, India Indonesia, Malaysia and Mexico. Tightening global financing conditions raise the risk of debt servicing issues.

Besides, tightening global financing conditions can impact countries exposed to high gross financing needs. They will be hurt from a reversal of capital flows. Countries like Argentina, Brazil, India, Malaysia and South Africa seek high gross financing due to elevated public debt are on the watch list radar screen,

While there are possibilities for spillover effect to the rest of the EMs to be limited, still the risk of a contagion effect remains high in EM. In particular the risk is high on those EM countries operating under the environment of fiscal and current account deficits as a percentage of GDP or commonly referred to as “twin deficits”,

The high risk countries are Argentina, Brazil, India, Mexico, and the Philippines who are in twin deficits. A crisis from any one of these countries can spreading within themselves since their respective ERMPI is above 2SD suggesting high risk to experience potential currency crises.

Meanwhile, knock-on effects on other EM countries like Indonesia, South Africa, and Turkey cannot be ruled out.

Although their respective ERMPI reading is less than 1 SD for Indonesia and South Africa while is between 1 and 2 SD for Turkey, implying the risk of potential currency crises is low for the former and moderate for the latter, still these countries are operating under the “twin deficit” environment.

Finally for countries like Malaysia and Thailand, although they are not operating under the environment of “twin deficit”, they are exposed to high debt and hence place them on the risk of contagion effect. More so with their ERMPI sitting between 1 and 2 SD.

Anthony Dass is AmBank Group chief economist.

Anthony Dass , emerging markets