Emerging Markets: What has Changed

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

1) Brazil’s state-owned oil company Petrobras finally released its audited results 

2) Brazil changed its methodology to calculate the current account deficit 

3) Russia continues to fight against further ruble appreciation 

4) The developments relating to China’s financial system continue 

5) Taiwan introduced limits on foreign investment in its corporate bond market 

6) The Turkish central bank kept rates on hold, as expected, but took some measures to push back against further depreciation 

Over the last week, Hungary (+4.8%), Brazil (+4.6%), and Russia (+4.4%) have outperformed in the EM equity space as measured by MSCI, while India (-4.5%), Thailand (-2.3%), and Egypt (-2.0%) have underperformed.  To put this in better context, MSCI EM rose 1.6% over the past week (for the fourth consecutive weekly advance) while MSCI DM rose 1.6%.

In the EM local currency bond space, Ukraine (10-year yield -127 bp), Thailand (-15 bp), and China (-15 bp) have outperformed over the last week, while Turkey (10-year yield +34 bp), South Africa (+19 bp), and Korea (+18 bp) have underperformed.  To put this in better context, the 10-year UST yield rose 6 bp over the past week.

In the EM FX space, BRL (+1.9% vs. USD), RUB (+1.7%), and COP (+1.3) have outperformed over the last week, while INR (-1.9% vs. USD), TRY (-1.7%), and ZAR (-0.7%) have underperformed.

1) Brazil’s state-owned oil company Petrobras finally released its audited results. The company booked R$6.2 bln in corruption-related costs, along with an R$21.6 bln in overall loss. This was an important step, since not announcing the result would break the covenant of some of its bonds. However, we doubt we are out of the woods yet. The investigation is still evolving and will surely continue to spillover to the country’s economic and political outlook.

2) Brazil changed its methodology to calculate the current account deficit.  As a result, the deficit relative to GDP jumped up to -4.54% from -4.5% in February.  Under the old methodology, the deficit was -4.2% of GDP in February.  From what we can tell, the revisions go back to January 2014 and resulted in increased deficits.  For the months January 2014 through February 2015, the average monthly revision was an increased $1.1 bln in the deficit, which partially explains why the deficit/GDP numbers were revised up.  Lastly, the upward revisions in the current account gap have increased its dependence on hot money flows.  Before the revisions, FDI covered about 67% of that gap.  After the revisions, FDI covers only 58%.  It's not just on the current account side, as FDI is starting to roll over.  The 12-month total of $59.4 bln in FDI is the lowest since October 2013.  We think these are very important developments, and ultimately BRL-negative.

3) Russia continues to fight against further ruble appreciation.  Aside from talking down the currency, the central bank decided to hike rates for USD funding.  This makes it more expensive to go short USD/RUB.  Although the measure had some impact after the announcement, the reaction was short lived.  We recognize the reasons for the rally (geopolitics, short covering, cheap valuations, oil rebound), but we prefer to stay on the sidelines on this one.  S&P affirmed its negative outlook on the country last Friday. Meanwhile, Fitch was said to have delayed its rating decision amidst expectations of a downgrade.

4) The developments relating to China’s financial system continue.  After regulatory changes that improve investors’ ability to short the Chinese local equity market, the government cut reserve requirements by 100 bp. This is the second cut in two months and was twice as large as the previous adjustment.  Separately, we got confirmation that the power company Baoding Tianwei is defaulting on a bond.  Although well-telegraphed, this represents the first time a state-owned firm has been allowed to do so.  This is an important signal and a small step towards reducing the endemic moral hazard in the Chinese financial system.  Lastly, securities regulator CSRC appeared to boost IPO issuance by saying it would review two batches of IPO applications per month, up from one currently.

5) Taiwan introduced limits on foreign investment in its corporate bond market.  The move suggests Taiwan policymakers are growing more uncomfortable with TWD strength, which is the second-best performer within EM and up 2% YTD.  With most EM currencies falling at the same time, Taiwan’s REER has been steadily increasing in recent months to near multi-year highs.  Also, Chinese officials announced they will open up RQFII quotas for Taiwanese financial institutions to invest in mainland markets. RQFII stands for offshore Renminbi Qualified Domestic Institutional Investors.  This measure should be implemented after the implementation of the Cross-Strait Service Trade Agreement, and should encourage capital outflows from Taiwan.

6) The Turkish central bank kept rates on hold, as expected, but took some measures to push back against further depreciation.  The bank increased the interest paid on lira required reserves and cut the FX deposit lending rates by 50 bp.  It looks like markets were expecting more and have taken USD/TRY to new record highs in the days after the announcement.  There is increasing market chatter of another emergency rate hike like last year.  This is becoming more and more likely, in our view, despite official pressure not to hike rates ahead of the June elections.