'This isn't '97 again': Why emerging markets can weather rate hikes
Tightening financial conditions in the US can infect emerging markets. This time around, EMs are certainly not immune, but not as exposed either.
The US Federal Reserve has initiated a long string of interest rate hikes and should soon give us a sense of how it intends to sell assets on its balance sheet. In the past, such initiatives fared badly for emerging markets (EMs).
At the end of 1993, the Fed started hiking rates from 2.97%, reaching 6.02% 18 months later in June 1995, causing the dollar to rise and investments to move back toward US shores – and arguably setting a detonator for the infamous South East Asia crisis of 1997. Up to that moment, everyone spoke of the “tiger” economies of Thailand, Malaysia, Singapore, South Korea, and others where annual growth was between 6% and 9%.
“As the dust settled, it became clear how badly damaged the tiger economies were by the financial crisis," recalls a recent article in the International Banker.
"The nominal GDP per capita between 1996 and 1997 had dropped by 43.2 percent in Indonesia, 21.2 percent in Thailand, 19 percent in Malaysia, 18.5 percent in South Korea and 12.5 percent in the Philippines. And stock markets had lost up to 70 percent of their value by early 1998.”
The “tantrums”
Traumatic episodes in EMs happened again in 2008 and in 2013, during what has been identified as the “taper tantrum”. After then-Fed Chairman Ben Bernanke announced in May 2013 his intention of reducing the Fed’s quantitative easing program, conditions soured in a dozen major emerging economies.
Another “tantrum” occurred in 2018 when the Fed started to reduce its asset holdings, but this time only two countries – Turkey and Argentina – suffered significant damage.
Many problems coalesced in the 1990s to create a perfect storm for the South Eastern tigers: overheated investment, inflated stock market values and property prices, inadequate currency reserves, unsustainable pegs of local currencies to the US dollar, and lack of financial oversight.
The 7% test
Conditions today are very different, giving EMs much more resilience. One key component is currency reserves, which gives a country a buffer to absorb any damaging impact of rising US rates and a strengthening greenback.
A rule of thumb for adequate currency reserves, as popularised by Fed Chairman Alan Greenspan in 1999, is that a country should manage external assets and liabilities in a way to be able to live without new foreign borrowing for up to one year, which translates into 7% of GDP. In 2013, 8 of 13 developing countries were well below that threshold, but by the end of 2020, only 2 were.
“These emerging markets have higher central bank reserves, lower foreign-currency debt and smaller current account deficits”, notes the Dallas Fed paper. “This suggests emerging-market balance sheets are in much better shape now than they were during the taper tantrum of 2013.”
The Brookings paper also notes other sturdier points in EMs: in 2013, among the most fragile countries, current account deficits averaged about 4.4% of GDP, compared to just 0.4% by mid-2021, while external resource flows had reduced significantly and real exchange rates were not as overvalued.
New tilt
After 1997, the situation in many key EM countries changed significantly. In the past, EMs were dominated by commodity-producing nations and economies leveraging cheap labour, states Craig Basinger, chief market strategist at Purpose Investments. "Today’s EM is dominated by Asia," he adds, "with a heavy technology tilt."
Furthermore, South Korea has acceded to developed nation status while the leading EM country, China, has evolved a substantial consumer economy and a respectable technology sector. The investment story now is very different:
“We like stocks domestically driven by consumption,” notes Lorraine Tan, Morningstar's director of equity research for Asia. Furthermore, while the US is tightening on all fronts, "China is expanding its monetary cycle."
"Chinese stocks are already down, so we may not get as great a market selloff, while a recovery could be faster," she says.
Other EMs, such as Malaysia and Thailand, are still very export-driven, exposing them more to US and Chinese financial tribulations. “But those stock markets are not overvalued by any means, many even trading at discounts because of Covid-19,” Tan highlights.
Emphasis on growth
But the general EM context is very different now from what it was in the past. Much of what happens there hinges on the growth path not only of the US but of China.
“With China slowing down, and the US, it’s hard to be very optimistic for emerging markets,” says Aidan Garrib, head of global macro strategy and research at PGM Global. He also points to a few exceptions that could show some resilience, like Brazil, Chile and the Czech Republic.
Elaborating on Brazil, he notes one could be more optimistic about it "because it exports industrial products, metal, oil, also food. Its more diversified base will make it more resilient than countries that import commodities, probably even more than oil exporters like Saudi Arabia, who must import food at inflating prices."
Purpose Investments' chief market strategist Craig Basinger shares Tan and Garrib's very cautious optimism. He likes the comparatively low valuations and good earnings growth of many developing countries, but is still wary of deteriorating financial conditions.
“When the world is experiencing tightening financial conditions, EMs tend to suffer more," he says. But that suffering will be nowhere near what EMs experienced in the past.
“This will not be 1997 all over again, with currency and debt crises,” advises Tan. Perhaps the fragility of EMs is not much greater than that of developed countries exposed to softening conditions in the US. and China.