EM contagion back with a vengeance as Turkey pops
LONDON: The plunge in the Turkish lira has set off a wave of selling across emerging market (EM) assets, reviving the spectre of contagion that has been the sector’s Achilles heel for decades.
Although the ripple effects may not yet be of the scale of the financial firestorms of 1997 to 2000 or the global financial crash of 2008 to 2009, seemingly indiscriminate selling of emerging markets as far afield as South Africa, Russia and Mexico was clear as Turkey’s crisis deepened.
There were hopes earlier this year that this sort of contagion had dissipated, with little spillover from a crisis in one country, such as Argentina or Brazil, to the wider asset class as whole.
But with the lira diving 13 per cent on Friday in its biggest oneday fall since the financial crisis, other currencies such as the South African rand and Brazilian real tumbled in its wake. It was the first real sign of intra-EM contagion since 2013’ s ‘ taper tantrum’, when the markets took fright at the prospect of the US Federal Reserve reducing its economic stimulus.
“It’s the usual classic emerging markets story where people wake up, see bad news in one country and start selling everywhere,” said Bart Turtelboom, chief executive at APQ Global.
On the face of it, similar market dynamics to prior emerging market blow ups are back at work again.
Robin Brooks, chief economist at the Institute of International Finance, said capital flows had been very large in the run up to the sell off, on a par with levels before the taper tantrum. In addition, late in the cycle, EM exposure builds up
It’s the usual classic emerging markets story where people wake up, see bad news in one country and start selling everywhere. Bart Turtelboom, chief executive at APQ Global
rapidly in a few places where good returns can still be had.
As a result, asset managers are now trying to reduce risk where they can, especially in the more liquid markets such as Mexico and South Africa, to cover potential redemptions and limit any downside.
“You need the cash to perhaps plug the hole or the losses in other positions in which you are stuck, so that causes the spillover and triggers a chain reaction,” said Cristian Maggio, head of emerging markets strategy at TD Securities.
Marc Ostwald, global strategist and chief economist at ADM Investor Services International Limited, added that the moves had been accentuated by poor liquidity: “The door is very big when you want to go in, and it’s a mousehole when you want to go out.
The really big contagion effect happens when people have to sell good assets to cover losses on bad assets.” Perfect storm
So why now? Market participants say it’s partly due to investors waking up to the high levels of dollar borrowing some emerging countries undertook during the easy money years - debt that needs to be serviced.
With the US Federal Reserve tightening and the dollar strengthening, borrowing costs for emerging countries are rising. While Turkey may be the weakest link, it is by no means the only country dealing with an asset/ liability mismatch.
Turkey, Argentina and Indonesia also sold off hard in May as investors fretted about rising US yields, but both Argentina and Indonesia took decisive action to contain this by raising interest rates to steady their currencies.
Turkey also raised rates then, but its response this time has been to stand pat, with President Tayyip Erdogan seemingly wedded to unorthodox monetary policy and commanding greater influence over the economy since his reelection in June.
At such a vulnerable moment, the US imposed sanctions on two of Turkey’s ministers - a move that Edward Park, investment director at UK-based Brooks Macdonald, said had acted as a catalyst for the market.
“US sanctions are the straw that broke the camel’s back,” he said. “This is a good example of a country that did relatively little to calm down the sanctions news and little to defend the currency. It’s a perfect storm in terms of market reaction.”
He pointed out that Turkey had tripled its US dollar liabilities over the last 10 years, taking advantage of cheap money to refinance itself.
“There’s been a lot of negative sentiment around Turkey but people are thinking that Turkey is not alone... and what could be the next country under fire because of its external debt liabilities?” Park said. — Reuters