There are two pressing questions in our mind on Emerging Markets (EM) countries i.e. whether a crack in EM countries will trigger a contagion effect or are there possibilities for a widespread crisis to be contained from spreading across the EM countries? Much will depend on: (1) their ability to repay USD denominated debt; (2) exposure to external financing requirements; and (3) the size of foreign investor pool in domestic-denominated debts. A contagion can be avoided if we differentiate the vulnerabilities within EM countries with strong fundamentals and otherwise.

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, especially on those EM countries operating under the environment of “twin deficits”. High risk countries are Argentina, Brazil, India, Mexico, and the Philippines facing twin deficits with high currency crisis pressure index with more than 2 standard deviation (SD), as well as on Indonesia and South Africa facing less than 1 SD while Turkey is between 1 and 2 SD in relation to currency pressure index.

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 1and 2 SD.

A. Can an EM 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 bondbuying 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 25bps 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%–3.00%.

• Meanwhile, we reiterate our view that the ECB will halt its QE 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 4Q2018 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 synchronized global growth.

• In the meantime, there are two pressing questions in our mind on Emerging Markets (EM) countries, namely: 1. Whether a crack in EM countries will trigger a contagion effect. Much will depend on: (1) their ability to repay USD denominated debt; (2) exposure to external financing requirements; and (3) the size of foreign investor pool in domestic-denominated debts. These issue will determine if the EMs’ assets are threatened by the confidence of investors who once felt the region to be comparatively safe. 2. 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.

B. Shift to risk-off environment

• 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. (See Table 1).

• 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 USD 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. (See Table 2)

• 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 40.0%. 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.

C. Identifying the next crisis

• In identifying the next crisis, the focus was on two major issues i.e. currency and debt. We are of the view that EM countries with a huge load of debts 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.

Potential currency crises

• A currency crisis can be defined as a sharp decline of more than 20% of a local currency against the USD. 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 are likely to potential currency crisis. Here, the readings from the ERMPI for each local currency vis-à-vis the USD is compared against a threshold which is two standard deviations (SDs).

• Should the reading of ERMPI breaches 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. (See Table 3).

• Now those EM countries who 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

• A debt crisis is the general term for a proliferation of massive public debt relative to tax revenues, especially in reference to Latin American countries during the 1980s, the US and European Union since the mid-2000s, and the Chinese debt crisis of 2015.

• 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 USD 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 USD borrowing are brewing. More so with the USD foreign-currency debt rising from US$4.5tril in 2008 to US$8.3tril in 2017 (See Chart 1). Countries on the watch list are Argentina, Indonesia, Mexico, Turkey and Philippines given their high foreign debt exposure as % of GDP (See Chart 2).

• At the same time, focus is also on EM countries maturities exposed to USD 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 (See Chart 3)

• 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 (Table 4).

D. Contagion effect is on the table

• 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 % 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 1and 2 SD.

Source: AmInvest Research - 2 Jul 2018