Contagion? Possible Second Round Effects for Emerging Markets

A decade on from the last financial crisis, the conventional wisdom is that that broad macro fundamentals are strong and that potential shocks from a hit on banks is a low probability event given the regulatory changes that have since beefed up capitalisation ratios for banks, coupled with new national or supranational instruments - especially in the EU - to provide backstop liquidity in case of any run on banks or general illiquidity due to shocks.

As I outlined in my last piece, the risk of EM wobblies is underway and affecting countries across all geographies, although there is a general bullishness that the scale will be limited and the impact contained.

Is this baseline valid?

Aside from basket case economies, Venezuela or Zimbabwe come to mind first, and those where credibility of policy is clearly the issue - Turkey being a case in point - it is indeed the case that the internal-external imbalances are less alarming as a genre for main EMs. Current Account deficits are not necessarily in nose-bleed territory and ditto with fiscal balances. Add to that FX reserves or months of import cover which the IMF focuses on for LDCs in particular. And a key lesson from the decade earlier and the SE Asian crisis in 1998 has been to have more flexible exchange regimes to take the brunt of adjustment. Russia's relatively successful stabilisation in recent years is a case in point.

That said, the risks of second-order impacts are under-valued.

One of the fascinating features of looking at biological equilibria models using game theory for viruses was how a seemingly salient long-lasting equilibria could be immediately and very quickly mutate into a contagion. Students of bank runs in the pre-Gold Standard era will be aware of how sentiment and confidence can turn into a riot - the herd instinct in short.

What are the potential sources of 2nd order or feedback loops?

1. Mr Trump. Irrespective of one's view of him personally and the fascinating never-ending soap-opera around his administration, he remains an "unknown unknown" in terms of policy predictability. Given that his tweets can move shares and markets, his spat with Turkey could, if continued, not only lead to a recession in Turkey but spillover onto neigbours and into the EU via the Western Balkans. This could also affect Turkey's position on opening refugee routes back into the EU.
2. China. The one emerging consistency of the Trump presidency's economic policy seems to be "correct" the modus-operandi of economic relations with China and to equalise the basis of bilateral trade and of investment policy in China that discriminates against Western investment vis-a-vis Chinese investment in the West. Mr Trump's escalation of additional tariffs on near 50% of bilateral trade with China and pressure on the likes of Apple to shift supply chains from China are examples that the pressure may not abate yet. China's tit-for-tat responses are programmed but have a limit - because ultimately its economic machine is reliant on trade surpluses, and with the US. A slowdown in external trade in China could set of a chain reaction.

• China's growth rate, even accounting for a little official massaging of figures, needs to be north of 5-6% to prevent social discontent in China.
• The elephant, sorry Panda, in the room is the potential spillover to the (in)stability of the Chinese financial system. The political-economy model in China means a mix of SOEs and a genuine private sector in tandem and with a legacy of bank lending to SOEs and to local authorities that could prove to be that catalyst that suddenly turns from illiquidity to mass insolvency. Whilst the Chinese could have perhaps played the US off against the other key western trading partners who also have increasing concerns about Mr Trump and his broader support for the existing post-War system of trans Atlantic system of economic and military relations, what they now find is a common position of the US+Japan+EU on this one issue.
• Regional impact in Asia: any financial and/real impact on the Chinese economy would quickly ripple across onto other Asian economies through trade and financial channels. So the baseline models that project Goldilocks scenarios of sustained growth and resultant strength of equity markets in Asia may be at risk in such an eventuality.

Source: FRED using BIS data

3. Competitive Devaluations: as shown in the Figure above, the CNY:USD has devalued by around 8% since February and devaluation is an obvious policy choice although it would create further monetary headaches to deal with issues of subsequent sterilisation requirements. However, a bit like the Death Star in Star Wars, once you're in the gravitational pull, it don't matter how strong the force is with you! Asian currencies in SE Asia will do the same - as was the case in previous episodes. Moreover, it may lead to further angst from the "devil's workshop" and further Trumpian action.

4. The risk of currency mismatches on liabilities: this is where there could be some serious pain where the capital account is heavily reliant on dollar-denominated portfolio flows and domestic debtors have domestic currency assets and cashflows but possibly dollar-denominated loans.

5. I am still not fully convinced about the sustainability for the EU. OK we all now know that the pre-financial crisis baseline that Greek risk equated to EU risk and akin to Germany's turned out to be a load of moussaka! As crises from Latvia to Romania to Greece have shown in the last decade, a common monetary regime and fixed exchange rate for the entire Euro-zone means that external devaluation is not a possibility. Hence the impact of any external shock to weaker economies from any sustained EM contagion in the EU would be that much greater.

6. Political impact: a rising anti-EU tide is afoot with Sweden the latest example. With Poland and now Hungary facing Article 7 sanctions for being increasingly authoritarian and threatening the basis of fundamental EU values (Freedom of Expression, opposition and freedom of press and judiciary) and the bond market spooking in Italy when yields doubled in a few hours last week, a further move away from the centre ground of European politics of the last 30 years could yet lead to major de-stabilisation of southern and eastern EU economies.

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.