Emerging market news

- compiled from information supplied by UBS

Emerging market debt: The worst is over

• Although the emerging economies are far from being out of the woods, we can draw some conclusions from the recent experiences for overall country risk. Countries with prudent fiscal policies over the past few years, a well-diversified economic structure, and better political and monetary institutions will likely overcome the prevailing difficulties and emerge with better long-term potential. A special feature of the current crisis emerged from the private sector – companies and households. The private sector in eastern Europe borrowed large amounts and did so in foreign currency which made matters worse over the past few years. Such leverage was not a major concern as long as global economic growth was strong and emerging market currencies were appreciating against funding currencies (such as the Swiss franc, euro or Japanese yen). However, as conditions deteriorated in 2008, such positions turned into a substantial risk and into contingent liabilities for sovereigns. Emerging market governments had to step in and support the local economies — especially the banking sector which had extended foreign currency loans. Russia was in the fortunate position of having significant foreign currency reserves and the ability to support its domestic economy. Other countries, such as the Baltics or Hungary, were less fortunate and had to rely on international support from the IMF or the European Union. The lesson learnt is to take any contingent liabilities from the private sector into account when analysing sovereign country risk. Key indicators in that respect are foreign currency borrowings by the private sector or loan-to-deposit ratios of the banking sector. 
• Emerging market assets have recovered since the start of the year despite the global recession that is hobbling developed economies and lower demand for emerging market exports. 
• There are tentative signs that the worst of the business cycle is behind us. However, the road to recovery may not be smooth.
• Eastern Europe appears to be the most vulnerable region, followed by Latin America, while Asia appears the strongest. Nonetheless, there are major differences among countries. 
• The availability of financing improved over recent months as international financial institutions like the International Monetary Fund (IMF) offered new credit facilities. Yet, cross-border bank credit flows will probably remain meagre, and portfolio and investment flows might be rather subdued in the coming quarters. 
• As the credit rating cycle has clearly turned, several countries face rating downgrades. Measures in place are probably sufficient to avoid major country defaults. However, the risk for selected debt restructurings remains elevated.
• Emerging markets as a region have mastered the recent crisis and the asset class has gained investor credibility. 

 

BRIC nations and the US dollar: the love-hate relationship continues

The BRIC (Brazil, Russia, India, China) conference held in mid-June in Russia may have been the first international summit inspired by bank analysts – the term BRIC was originally coined by an investment bank analyst. However, the growing wealth of these nations, and their desire for more political influence on the international stage, is clear.

There was substantial anticipation surrounding the conference after several different officials from the countries made strong statements suggesting they wanted to dramatically limit their US dollar exposure. Specifically, Russian President Medvedev had expressed sharp concern about the stability of the US dollar leading up to the summit.

Comments suggested a switch from Treasuries to International Monetary Fund bonds. While there is a clear desire not to be as exposed to one currency, these particular bonds are not a long-term alternative.
First, the IMF is not a country with a central bank; rather, the institution is raising capital as a one-off event. Second, the IMF’s “currency” is an accounting unit only, called Special Drawing Rights (SDR). Nobody actually trades or invests in SDRs. And finally, SDRs are about 44% US dollar linked, so by buying SDR-based bonds, the countries would not be eliminating US dollar exposure.

At the end, the four leaders did discuss the need for a “more diversified” monetary system, but there was no mention of currencies in the official statement. They did not put forth an aggressive anti-dollar proposal. Just beforehand, Russian Finance Minister Kudrin went so far as to say that the dollar was in “good shape” and suggested there was no alternative as the world’s reserve currency. 

The dollar should slowly weaken over time, targeting EURUSD in one year and an even weaker dollar against some emerging market currencies. However, we do not look for a dollar collapse due exactly to the reasons that the BRIC countries did not in the end use their collective voice to criticise the dollar, primarily based on two issues:

1. BRIC countries and others have a large percentage of their reserves in dollars; according to the IMF the dollar represents about 65% of the total. Because these countries’ savings are in dollars, they do not want to drive the value of the dollar down. Rather, they will seek gradual ways to reduce their exposure that does not destroy the purchasing power of their savings.
2. Many emerging markets including the BRICs keep their currencies artificially low relative to the dollar to support exports, in effect pursuing a strong dollar policy. As these countries still export a large portion of their goods to the US or to countries with currencies that are formally or informally tied to the US dollar, the dollar still  makes the most sense against which to target their currency. As long as they have export-oriented growth models and seek to export their way out of an economic slowdown, they will want to keep their currencies cheap relative to the dollar.