Risks of a full-blown emerging market debt crisis are being fuelled by Sino-US trade tensions and currency volatility, led by a weaker renminbi and a stronger dollar, leading economists and fund managers have warned.
Raghuram Rajan, former Reserve Bank of India governor, told GlobalMarkets that it was “not quite the perfect storm yet, but it’s getting quite stormy out there”. He said the likelihood of a deeper crisis would depend on how macroeconomic vulnerabilities interacted with countries’ leverage positions that had built up over the past decade.
Hung Tran, executive director of the Institute of International Finance, said China was the country most likely to test those limits. “International investors are keenly aware of the next shoe that could drop: a weakening of China’s growth and the RMB by more than the soft landing the authorities are trying to engineer,” he said.
A sharp depreciation of the RMB would put significant new pressure on EM currencies that many economists already considered undervalued. However, Tran told GlobalMarkets that “contagion with clear differentiation” meant the 2018 crisis had — so far — been less acute than it was in 2013 for stronger EM countries.
But weaker countries have been harder hit. Tran said Turkey’s and Argentina’s currencies had dropped roughly 35%-40% since March, double the average 20% EM drop between 2013 and 2016.
The second key risk is a stronger dollar, should the Federal Reserve hike interest rates more sharply than markets expect. Tran said this could prompt carry trade investors to mitigate losses by unwinding positions. In this scenario, even countries that had worked hard to reduce their current account and fiscal deficits since 2013 could be vulnerable.
Adam McCabe, head of Asian fixed income at Standard Life Aberdeen, said investors needed to be cautious, although he insisted it was important to determine what kind of foreign investors dominated a particular market. “In some local markets, strategic investors account for the majority of foreign ownership,” he told GlobalMarkets. “Provided policymakers continue to pursue a credible course, then many foreigners will stay the course.”
FOREIGN CURRENCY DEBT
McCabe said EM foreign currency debt worried him more. Tran and Rajan both echoed that, highlighting how dollar strength and foreign investors’ retreat back to developed markets would make this far harder to refinance. “We’ve seen this many times before and I’ve warned about it in the past,” Rajan said. “Countries have to be prepared.”
Tran said governments needed to monitor corporate sector foreign currency borrowing, since this was where the main problem lay. It accounted for 78% of the record high $5.5tr foreign currency EM debt load, he added. “They should discourage currency mismatches and put foreign exchange liquidity backstop facilities in place to help cushion the impact of weakening currencies on the outstanding debt burden,” he said.
But Tran said governments needed to take a balanced approach — cultivating domestic bond markets while at the same time making sure they built up a domestic institutional base to counter potential foreign outflows.
By Jackie Horne and Rashmi Kumar