Europe, not EMs, at the vortex
In the summer of 1998, Russia’s financial crisis stemmed from the oil price plunge that followed the Asian financial crisis. Today, the worry is that Russia’s fall is causing a cycle of contagion which could pull down even decently managed emerging economies. Unusually, this collapse is happening just as the world’s biggest asset allocators prepare to effectively shut up shop. It is rare to get a full blown crisis over year-end simply because volumes are so thin, however the concern must be that the absence of strong two-way flows in the coming two weeks allows markets to gap lower in a disorderly fashion. Mark-to-market requirements do not disappear just because it’s Christmas. Emerging markets are being hit irrespective of whether they are net energy exporters or importers. Indonesia has seen its currency fall back to 1998 levels. The potential for an indiscriminate contagion can be seen in India where the rupee has lost almost 3% in three months despite an improved external position and better inflation outlook. And then there is the potential for events to spur an exit by foreign investors: witness the political crackdown in Turkey and Thailand’s recent intraday 9% plunge, in part on fears of a difficult Royal succession.
But for contagion to be a real threat, what is the transmission chain? A stronger dollar perhaps? Certainly, one can argue that that the structural strengthening of the dollar means that investors should avoid entities with negative US dollar cash flows. Prime candidates would be high cost national oil companies, and yet looking across the broad EM universe there is no evidence of a major blowout in credit spreads. Another risk was that the Federal Reserve would firm up its forward guidance on future interest rate rises at its latest FOMC meeting. Perhaps the simpler proposition is staring us in the face. A decade long investment boom in the energy sector is coming to the end and in the process financial investors are being harshly squeezed. At the same time, Russia faces a painful macro-economic adjustment just when it is cut off from debt capital markets due to sanctions. Russia’s recent action to raise benchmark interest rates 650bp to 17% seems likely to spark a further exit from the rouble. Certainly, Moscow’s scope for maneuver is limited; the Central Bank of Russia may have about $400 bln of foreign exchange reserves remaining, but about half of that is tied up in illiquid sovereign wealth funds. The rouble rate hike looks like a desperate effort to preserve the liquid portion. As such, attention is increasingly focused on the potential for a Russian debt default as occurred in 1998 – not many countries have sustained nominal rates approaching 20% for any period.
And this brings us to Europe which has been at the centre of the storm in recent weeks. In the last seven trading sessions, the main equity indexes in France, Germany and Italy are lower by almost 10%. Such moves reflect fears of renewed political uncertainty in Greece and the possible return of 2012-style systemic risk across the eurozone. Investor panic also reflects the failure of the European Central Bank to properly communicate over any move to a full blown quantitative easing. But there is also the reality that the underbelly of the oil and gas boom is the European banks. While the US shale expansion seems to have mostly been financed via capital markets, the exposure of the European banks to Russia is not insignificant, and it is mostly with the usual suspects in France and Italy which can ill afford another bank recapitalisation.
The potential for this market rout to morph into a more serious financial crisis cannot be ruled out. But rather than being a reckoning for emerging markets, this looks like payback for quite specific sins.