Delever­ag­ing in the emerg­ing world

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

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