Rising developed market bond yields and low emerging market premia could put more pressure on flows from developed to emerging markets. This will undermine the search for yield in emerging market debt markets.
So far, the rising external financing requirements of emerging markets have been met by strong investment flows into debt instruments. With foreign direct investment and equity flows lower than the averages of the past five or 10 years, the financing of the larger emerging market current account deficits has relied on debt flows.
This is worrying because the improving situation in the developed world will have a negative impact on emerging markets.
Four vulnerable countries
India, Indonesia, South Africa and Turkey are the countries where the dependence on foreign capital has been the highest recently. Their current account deficits have been either high or rapidly increasing towards uncomfortable levels.
In Indonesia, the deterioration has been the most dramatic, from a small surplus in 2011 to a deficit of 3 per cent in 2012. In Turkey, there has been a sharp improvement from 10 per cent in 2011 to 6 per cent last year. In India, the deficit has not changed much in recent years, but a 5 per cent current account deficit in combination with a structurally high fiscal deficit of 6 per cent remains a concern. South Africa has the most negative picture, with a rapidly widening current account deficit (by 3 percentage points in the past year to 7 per cent) and a ‘sticky’ budget deficit of 5 per cent.
So far, exchange rate movements have not been dramatic. The South African rand has been the weakest, depreciating by some 10 per cent since the summer of 2012 and 30 per cent since the third quarter of 2011. The Indian rupee has hardly moved in the past quarters, but it has weakened by 20 per cent since the third quarter of 2011. The Indonesian rupiah and the Turkish lira have been rather more stable, the former thanks to foreign exchange interventions by the central bank and the latter because of particularly strong portfolio debt inflows.
Given their large macro imbalances, the currencies of these four markets remain vulnerable to a sharp correction. All four countries rely heavily on speculative inflows. India and South Africa have large structural deficits and need a political breakthrough to tighten economic policies and carry out structural reforms. At this point, it is difficult to see much progress in the coming years.
Of the four countries, Indonesia is the country with the best macro fundamentals: a low external debt ratio and both fiscal and current account deficit still at a reasonable 3 per cent of GDP.
But the rapid widening of the deficit and a lack of willingness to tighten policies ahead of next year’s elections make Indonesia more vulnerable than it looks at first sight.
Valentijn van Nieuwenhuijzen is head of strategy at ING Investment Management
Things to watch
1. The widening risk gap between the BRICs and US market
2. Depreciation of Japanese yen will have a negative impact on exporters from other Asian countries
3. Currencies in India, Turkey, Indonesia and South Africa remain susceptible to a significant correction
