Emerging Markets: What Has Changed

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

1) Russia continues to liberalize the currency and move to an inflation targeting regime

2) Political risk is rising in Poland

3) South Africa came under renewed rating downgrade pressures

4) The Chinese yuan’s one-way depreciating bet appears to have ended

5) The US Supreme Court refused to hear Argentina’s appeal regarding its defaulted debt

6) Kenya and Ecuador have issued debt of their own

7) Vietnam devalued the dong for the first time in a year

Over the last week, South Africa (+1.3%), Taiwan (+1.2%), and Peru (+1.1%) have outperformed in the EM equity space in local currency terms, while Egypt (-4.6%), Argentina (-4.2%), and Pakistan (-3.7%) have underperformed. To put this in better context, MSCI EM fell -0.4% over the past week.

In the EM local currency bond space, Turkey (10-year yield -19 bp), Sri Lanka (-7 bp), and Korea (-7 bp) have outperformed over the last week, while Ukraine (10-year yield +25 bp), India (+14 bp), and Russia (+8 bp) have underperformed. To put this in better context, the 10-year UST yield was down 3 bp over the past week.

In the EM FX space, HUF (+0.7% vs. EUR), ILS (+0.4 vs. USD), and BRL (+0.2% vs. USD) have outperformed over the last week, while INR (-1.4%), IDR (-1.2%), and TRY (-0.8%) have underperformed.

1) Russia continues to liberalize the currency and move to an inflation targeting regime. Authorities will reduce the amount of daily intervention and widen the intervention band to 5.1 rubles from 3.1 previously. It also increased the amount needed to shift the band. The idea is to shift to an inflation targeting regime sometime next year. Separately, the central bank is increasing its financial assistance to help refinancing needs by local lenders. The combination of weaker growing and the Ukraine crisis has put severe strains in funding for corporates and local financial institution. Still, note that the Micex index has been one of the top performers globally over the last few weeks, rebounding nearly 20% from its late April lows.

2) Political risk is rising in Poland. In the aftermath of revelations that central bank Governor Belka may have inappropriately colluded with the government, junior coalition member Polish Peasants Party said early elections should be “seriously” considered. Elections are not due until 2015. As it stands, it does not seem as if Belka will resign, but many are questioning whether this crisis will make the bank less dovish in order to avoid giving the appearance that it is trying to help the government.

3) South Africa came under renewed rating downgrade pressures. Last Friday, Fitch cut the outlook on its BBB rating for South Africa from stable to negative. The agency revised down its growth forecasts for the country at the same time, citing strikes, high wage demands, and electricity bottlenecks as negative supply-side shocks. Later that day, S&P announced that it had downgraded South Africa from BBB to BBB- with a stable outlook. Moody’s remains the outlier at Baa1. Further downgrades are likely, as our own model has had the country in the BB/Ba2/BB area for several quarters now.

4) The Chinese yuan’s one-way depreciating bet appears to have ended. Last week’s data, beginning with the larger-than-expected trade surplus and running through the higher CPI figures, loan data, and industrial output, investment and retail sales, lend support to our assessment that the Chinese economy is stabilizing and that the currency no longer needs to weaken. Targeted but limited government stimulus measures have helped. Taken in conjunction with the significantly lower fixes in USD/CNY last week, it appears that the one-way depreciation bet for the yuan is in the process of being replaced by sideways trading with greater two-way risk.

5) The US Supreme Court refused to hear Argentina’s appeal regarding its defaulted debt. This basically leaves the country having to comply with a lower court’s order to pay holdouts in full before making any payments to bondholders that accepted the restructuring terms. The next restructured bond payment is due June 30, leaving the government very little time to negotiate any sort of settlement to avoid outright default. Argentina doesn’t have enough money to fully pay off the holdouts (in a May 27 filing, the government estimated a total cost of $15 bln), but we believe a default would have limited contagion or spillover to others in EM.

6) Amid the drama regarding the ruling for Argentina’s defaulted debt, it’s worth noting that Kenya and Ecuador have issued debt of their own. Kenya issued a 5-year bond at 5.875% and a 10-year one at 6.875%, which was reportedly more than four times oversubscribed. Ecuador, meanwhile, placed its first international bond since it defaulted in 2008, $10 bln worth at 7.95%. The issue follows a loan by Goldman Sachs worth $400 mln, borrowing billions from China since the default, and a buyback program on defaulted debt to pave the way for this issue. We remain concerned that weaker EM credits are issuing debt now at such depressed yields, but the quest for yield by global investors continues.

7) Vietnam devalued the dong for the first time in a year. The reference rate was moved 1% to 21246, and the dong is allowed to fluctuate +/- 1 percent. In the grand scheme of things, this will really have little impact. Inflation is running around 5% annually, so a 1% nominal depreciation is unlikely to have much impact on exports and export competitiveness.