Emerging Markets: What has Changed

(from my colleagues Dr. Win Thin and Ilan Solot)

Emerging market equities and fixed income as asset classes have been hit hard by the storm caused by the dramatic short squeeze of the Japanese yen, which was an important funding currency for the past six months or so, and the backing up of US interest rates amid talk that the Fed may taper its asset purchases soon.  The MSCI Emerging Market index has fallen 11.5% since May 22 and is at its lowest level since last July.  The premium offered by emerging markets over Treasuries has widened dramatically in recent weeks.  Outside of the price developments, this is what has changed in the EM space, in our view.

1) The political situation in Turkey is in its first stages of simmering down

2) After a slow start, Indonesian authorities are starting to take action

3) The Brazilian government is signalling that the USD/BRL 2.15 is the line in the sand

4) India steps up action to stabilize the rupee; markets continue to ignore it

1) The political situation in Turkey is in its first stages of simmering down. A representative of the ruling AK party stated that they are open to discuss a referendum on the future of the Gezi Park (which sparked the protests). On the financial front, Governor Basci is moving ahead with his “special days” policy of restricting liquidity to support the currency. It looks to us that the situation will remain fragile, but will start to stabilize.

2) After a slow start, Indonesian authorities are starting to take action. The central bank unexpectedly hiked rates by 25 bp to 6.00%, surprising all forecasters, and also raised the deposit facility (Fasbi) by 25 bp to 4.25%. In addition, the bank resumed its program of buying local bonds and injecting USD in exchange. All these measures are in line with our view that they are very committed to stabilizing the exchange rate. Although we are not medium-term bullish IDR by any means, we still think authorities will be relatively more aggressive (and successful) in containing depreciation than many other EM countries in the short term. Foreigners have pulled $1.9 bln from local assets in the last couple of weeks, but we suspect this trend will start to slow down. Foreign reserves stood near $105 bln in May, down from the 2011 peak near $125 bln, but still high enough for the central bank to help deal with the USD shortage as needed.

3) The Brazilian government is signalling that the USD/BRL 2.15 is the line in the sand. They removed the 1.0% IOF (tax) on dollar short positions in derivatives, first enacted in mid-2011 to prevent currency appreciation. This follows the reduction of the IOF on local fixed income products from 6.0% to 0%. Their success has been moderate: there has not been a decisive break higher, but on the other hand, they have not been able to inspire enough confidence to reverse the trend. There are more of these macroprudential measures impacting FX that can be unwound to support the BRL. In addition, the central bank will continue to do its part with swap and spot interventions, as well as rate hikes. We still think they will have considerable success at this point, and that BRL will outperform other EM currencies.

4) India steps up action to stabilize the rupee; markets continue to ignore it. In another effort to stem the rupee’s fall, the Securities and Exchange Board of India raised the investment limits of foreign investment in government securities by $5 bln to $30 bln. However, only long-term investors will be able to benefit (i.e. those registered as sovereign wealth funds, endowments, or multilateral agencies, insurance/pension funds and central banks). The local bond market has lost $3 bln in foreign capital over the last two weeks. Unlike the case of Indonesia and Brazil, we doubt the measure taken by Indian authorities will have as much success in controlling short-term currency moves.