Economists issue current account deficits warning

Experts have warned emerging market investors to avoid economies with large current account deficits because they will be hardest hit by a change in US monetary policy.

Many emerging market countries have fixed their exchange rates to the dollar as a way of maintaining stability for their currency, a practise known as pegging.

The US policy of asset purchases, known as quantitative easing, has led to a weaker dollar, which has in turn helped boost US exports and sparked economic growth.

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But with the Federal Reserve set to announce this week how it will begin to reduce the size of its asset purchase scheme the dollar is likely to appreciate, bringing pegged currencies with it.

A stronger currency would be manageable in the US because economic growth appears entrenched but a stronger currency in weaker developing economies could have an adverse effect.

“There are lessons here for emerging markets that peg or heavily manage their exchange rates against the dollar,” said Joshua McCallum, senior fixed income economist at UBS Global Asset Management. “The countries that will be most at risk are those that have current account deficits, or have seen their current account deficits deteriorate rapidly. This is a warning that their currency may have been overvalued, and that they could come under pressure from the market.”

Mr McCallum said the countries with the largest current account deficits included Turkey, South Africa, India, Chile, Peru, Egypt, Poland and the Czech Republic.

Robert Spector, a fund manager at MFS, said emerging countries most exposed to commodities and those with large amounts of foreign debt ownership or large current account deficits would “feel the most pain”.

“For example, Indonesia, which was the darling of Asia, is now the worst performer in the past three months – down by more than 20 per cent,” Mr Spector said.

“As growth has slowed, private spending has fallen and investors have exited the bond market. Indonesia’s current account deficit has grown to nearly 4.4 per cent of GDP – the highest in more than two decades.”

But Mr Spector said while some investors had argued emerging markets were entering a period similar to the Asian financial crisis when several currencies crashed and government debt levels spiralled, the balance sheets of most corporates and individuals now showed the situation was not as dire.

“Bond markets have developed significantly since the late 1990s,” he said. “Companies have taken on longer-term, local currency debt to fund their growth. Government balance sheets are far healthier now, with large reserves and import cover ratios.

“What is clear is that businesses that have done well recently, because of high leverage and cheap financing based predominately on quantitative easing, will suffer significantly moving forward.

“We are particularly concerned about businesses with high levels of foreign currency debt that are not matched to their underlying cash flows.”

Kevin Gardiner, chief investment officer, Europe, at Barclays, said emerging markets could be hit by further outflows as conditions in the west normalise.