Thursday, 13 September 2018

EM wobblies: deja vu Contagion?

Students of a certain vintage may recall the Junior School favourite (or not!) in the prehistoric days before the advent of mobile screens:
"Hungary was hungry, ate Turkey, slipped on Greece and broke China"
This basic kiddy whatchamacallit is one that comes to mind every so often when we experience Contagion across economies, most notably affecting EM economies in the transition, developing or LIC/frontier space. Are we again in the midst of something like 1998 when writing about the wave from South East Asia that spread to Russia and central Europe?
The world is even more inter-connected and the share of global wealth increasingly shifting towards the newly developed world and emerging economies. The transmission channels for possible vulnerability, economic shocks and volatility are therefore more synchronised than in the good old days of pre-Internet, Facebook and so-called Fake News. The pattern of increased synchronicity of business cycles across the globe means that economic policy can often be pro-cyclical in tandem across regional economies and ditto with short term external flows and a mis-match of currency exposures on national and private balance sheets, leaving economies and both private and public sectors to the mercy of a change of sentiment that can start with an isolated idiosyncratic issue and spread from one country to another.
Its clear that bad economic management has been the curse of many emerging economies although as we saw with Greece and possibly soon Italy, that this is not unique to developed economies but they at least tend have more sound governance and institutional structures - and importantly backstops from the EU and the IMF to plug finance gaps on the balance of payments and help plug gaping short-term holes on public finances.
The pains in Argentina, Venezuela and possibly South Africa obvious examples of the current geographical spread of woe. The pains of Turkey were, yes, affected by the macho stand off between Erdogan and Trump, but the increasingly authoritarian rule in Turkey with perhaps a Pretorian policy guard is in stark contrast to the more nimble approach taken by Putin in Russia where the central bank has been more orthodox and nimble in managing monetary policy.
Country specificities will always exist but common exogenous shock is the reversal of QE across the developed world. The tightening monetary stance in the US has had the most attention but the ECB and the Bank of England too are starting the unwinding of easy money that has found its way across asset classes - and to high yield investments in emerging and frontier markets.
If the taper tantrum that led to a surge in the yield of US Treasuries was the starter, we are now moving to the main course! The out-flow of funds is affecting not only the policy-wonky countries but other EM countries as confidence in the EM asset class abates and the age-old issue of the herd instinct kicks in.
As in 1998 the sudden outflow of hot money can leave countries gasping as exchange rates plummet, exposing currency mis-matches of FX borrowing and putting countries with Current Account imbalances on watch - witness the impact on India - and one that is likely to get worse before getting better.
The big unknown is the impact on commodity prices that affected developing and Low-Income countries (LICs) in the Africa-Caribbean-Pacific region (or ACP as the EU calls it in the aid jargon). Many of the poorer LICs were pounded during the 2008-09 financial crisis and needed sizeable budget support from the EU and development banks. One has to be vigilant for them.
China is a big guzzler of commodities so watch China. The considerable deceleration in broad money expansion is a positive sign to reign in dodgy lending policies, especially at a sub-national level but will put a brake on domestic demand. Add the risk of a sustained and accelerating trade tensions with the US and voila...
Transition Economies? Russia may take a further hit although it has taken plenty due to the sanctions it has faced and recent post-Soviet history shows that when Russia sneezes the CIS catches a cold. A rebound in oil prices may help to cushion the impact and neighbouring economies are not so heavily exposed to flight of international capital.
And yet and yet. There will undoubtedly yet be a few unforeseen surprises out there in terms of international bank lending. The likes of Serbia faced the music in 2009 but Venice Agreements under the EBRD helped to maintain credit lines to domestic banks reliant on external capital lines. This may be the transmission channel to watch and which oddly may well affect developed Europe and banks there.
Banks in Greece may be exposed to the Western Balkans, those in Spain to South America and those in Germany and France to Turkey. Have the ECB and other EU financial reforms in the last decade made banks sufficiently secure against the potential shocks in the offing? Time will tell.
The big elephant in the room in the EU may be Italy. In the aftermath of the horrific collapse of the bridge in Genoa, Italy wants to spend big on infrastructure and this means breaking the noose of the Stability pact and expanding its fiscal deficit. The new government is hostile to the EU, an increasing common phenomena amongst the EU electorate, and already talking of withholding payments to Brussels. With yields on government debt on the up and a debt burden over 130%, it doesn't take too much effort to figure out significantly alarming tail risks.
The potential second order effects and likely impact on mature debt and global equity markets are for another day but if previous contagious episodes are to go by, this is more likely than not.

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