Deleveraging in the emerging world

There has been a lot of talk in recent weeks about the collapse in emerging market currencies, with extravagant comparisons to the 1997-98 crisis. In reality, there is no “crisis”. Over the last three years an equally-weighted index of major emerging market currencies has fallen no more against the US dollar than an index comprising the euro and the yen. And despite all the recent turbulence in financial markets, there have been no signs of unusual stress in short- term funding markets, or of a credit crunch in any large emerging market economy.

Yet, although talk of an immediate crisis is exaggerated, there is a very real longer term adjustment under way as emerging market currencies have depreciated against the US dollar and emerging market corporates are forced to deleverage—an adjustment that will continue to depress both demand and asset prices in the emerging world over the medium term.

There is a big difference between currency depreciation in developed markets and emerging economies. In Europe and Japan, currency weakness is part and parcel of domestic reflation policies. By contrast, for emerging market economies depreciation tends to be deflationary. Falling currencies accelerate the reversal of the carry trades through which the emerging markets have built up foreign currency debts of some $6trln, denominated principally in US dollars. And because the accumulation of those foreign currency debts encouraged, via the transmission mechanism of local banking systems, a build-up of domestic currency debt, the unwinding now under way is leading to a general deleveraging within emerging markets which is severely depressing aggregate demand.

In the years following the 2008 financial crisis, manufacturers, transport groups, utilities, property developers and other large emerging market corporates took advantage of low international borrowing costs to sell US dollar bonds to international investors. Many then simply deposited the US dollar proceeds with local banks, using the funds as collateral against which they were able to borrow more cheaply in their local currencies. Those deposits then had a multiplier effect in local financial systems, helping banks extend local currency credit to other customers. As a result, on average since 2009, domestic credit in the emerging markets has grown 5pp faster than gross domestic product, pushing the ratio of domestic bank credit to GDP up to 90%, almost matching the peak reached in developed markets on the eve of the financial crisis.

However, with the US currency strong and international demand for emerging market debt now looking sated, it has become considerably more expensive to borrow in US dollars. As a result, the carry trade is being unwound, which is leading to a massive contraction in emerging market loan books and a deep slowdown in the velocity of money. In the past, such a combination of a maturing credit boom and slowing growth typically led to severe financial stress. This time around, better macroeconomic policymaking, stronger institutions, and better risk management—evident in longer debt maturities and reduced net foreign currency exposure—mean emerging markets are more resilient.

Nevertheless, credit tightening in the emerging markets puts the world in an uncomfortable position. The expansion of domestic balance sheets in the emerging markets following the 2008 financial crisis helped prevent the global economy from sinking into outright recession, as emerging market demand cushioned the impact of deleveraging in the developed economies. Now, however, it is questionable whether the anemic recovery of demand in the developed world will be sufficient to offset the slowdown in emerging markets. So what should investors expect as the deleveraging process takes hold?

Sales will remain weak, if not in recession, both in emerging and developed economies. Even if emerging market-led deflation raises disposable incomes in the developed world by reducing import costs, encouraging rich world consumers to re-leverage, the effect will be offset by the expectation of tightening from the Federal Reserve.

As a result, no further upward re-rating of equity valuations appears likely. Risk asset returns will remain poor, with rising volatility. In such an environment, equity returns will be driven by the ability of companies to grow earnings through margin expansion. We expect Japan to continue to rebuild margins, with Europe to follow.

As emerging economies increasingly take the adjustment on their current accounts, emerging market currencies should start to stabilise, even as nominal growth remains sluggish. The ability to ease monetary policy to keep real rates down and moderate the output slowdown will distinguish the medium term winners from the worst hit. China, India and Indonesia have the greatest room to ease.

The greatest risk to this muddle-through scenario is a further devaluation of the euro and the yen. Not only would this mean a further strengthening of the US currency and hence even tighter financial conditions in the US dollarbased emerging market world, it would also undermine European and Japanese consumer demand for goods imported from emerging market economies.