Concern has been growing about the impact the US Federal Reserve’s reduction in the scale of its bond-purchasing programme will have on emerging markets.
With the world’s largest economy showing something of a recovery of late, its central bank is starting to dial back its longstanding ‘quantitative easing’ programme of flooding new money into the economy.
This reduction in the creation of vast quantities of new dollars is expected to make the currency more attractive to foreign exchange speculators, who are therefore more likely to buy in and boost its value relative to other currencies.
For investors, this has raised the spectre of past crises in emerging markets that were caused by greenback strengthening. Mexico’s ‘tequila crisis’ of 1994 and the Asian crisis of 1997 and 1998 are cases in point.
“With the Fed finally removing its stimulus, another period of dollar strength is entirely plausible and possible,” said Stewart Robertson, economist at Aviva Investors.
There are reasons for believing that the emerging markets are better placed to withstand a dollar resurgence this time, including the expansion of local currency government bond markets – where non-US economies issue bonds in their own currencies.
But Mr Robertson insists several emerging markets will be under pressure.
He highlights India, Indonesia, Brazil, Turkey and South Africa, a group dubbed ‘the fragile five’ by economists. They are also known as the ‘twin deficit countries’ for having budget and current account deficits.
In contrast, South Korea does not have those fundamental imbalances and is among the less vulnerable, said Mr Robertson.
Emerging market bonds were boosted in the past few years by a wave of new interest from global investors, seeking better levels of bond income than those being paid in western markets where interest rates have been at all-time lows.
This influx of foreign cash pushed yields on emerging market debt down, meaning prices of bonds rose, and caused the emerging economies’ currencies to strengthen against the dollar. Much of this foreign capital was used for capital investment projects in emerging markets, explains David Lebovitz, global market strategist with JPMorgan Asset Management.
US Fed chairman Ben Bernanke’s allusion last April to the fact that US interest rates would be heading higher on the back of improved economic growth prompted an exodus of foreign money from the emerging markets back to safer investments, such as US treasuries.
This meant the source of foreign funding for these massive investment projects was no longer there, Mr Lebovitz says.
“Broadly speaking, these emerging markets need to figure out how to organically finance growth going forward; they can’t be reliant on cheap money courtesy of the major developed market central banks, because as we can see that time is slowly getting away from us,” Mr Lebovitz asserts.
Gautam Chadda, director of investment consulting at RBC Wealth Management, agrees the emerging markets with twin deficits may come under pressure this year as the dollar appreciates and as the reduction of bond purchases by the Fed gains momentum.
But Mr Chadda said because fewer emerging market currencies are pegged to the dollar there would be fewer countries put under strain from a greenback strengthening.
“We see some investment opportunities on a select basis in countries with healthier fiscal and current account balances, such as Mexico and China,” he said.
David Riley, head of credit strategy at BlueBay Asset Management, believes that those who fear a rerun of the foreign payments and credit crisis at the sovereign level in the major emerging markets are missing the greater present concerns – a lack of growth and politics.
“In the past couple of years, we have had a rising tide of easy money lifting all boats,” he says. “As the tide subsides, there are going to be some emerging markets that will be exposed and others will be fine. The challenge for investors will be to pick and choose winners and losers.”
Mr Riley favours Poland, Mexico and South Korea, while India and Brazil have been struggling, but making progress with policy adjustment.
Thanos Papasavvas, strategist at Investec Asset Management, expects the dollar to strengthen only against the yen in 2014 and 2015, and not against the euro, sterling or broad emerging markets.
Yields on local currency emerging market debt are “very attractive”, he said.
Mr Papasavvas believes the emerging debt markets have already priced in the risk of ‘tapering’ by the Fed, and tightening is still years away. Countries such as India, Indonesia, Turkey and Brazil will not have a destabilising impact on the asset class.
He favours Indonesia, for example, among markets included in the JP Morgan GBI EM index, as he regards the currency as cheap, the country is addressing its current account deficit and he expects a positive outcome from elections. He also likes South Korea and Taiwan, but is underweight Singapore.
Another contrarian voice is Jan Dehn, head of research at Ashmore Investment Management. He believes that although the dollar has lost roughly 15 per cent of its value against the euro during the past 18 months, this has priced out the eurozone crisis.
From 2016, as growth and inflation pick up in the US, the Fed is unlikely to be able to absorb the enormous amount of liquidity it has printed, Mr Dehn says.
He believes the US is likely to opt to erode its massive debt stock through inflation and devaluation of the dollar, causing the emerging market currencies to appreciate strongly.
