Throughout the current credit squeeze, emerging markets have been in vogue. That irony hasn’t been lost on commentators, who have rushed to point out the neat symmetry to the 1998 Tequila crash and Russian default. This time, of course, the problem is Stateside.
That notion has been bolstered by the continued strength of China and also the big oil producers, such as Russia, flush with petrodollars and riding the crest of an equity, rather than a debt, wave. Indeed, a lack of complexity in local debt markets has been a surprising boon – Lithuania, for its sins, isn’t a global centre for ABCP engineering.
But according to a new report from Standard & Poor’s it is a fallacy to assume EM sovereigns are in some way insulated from the credit storm. As in the past, emerging markets will suffer as the credit downturn forces investors such as hedge funds to sell assets in order to stay liquid:
Facing redemptions and financiers that are demanding more collateral for their loans, hedge funds have few other options than to sell off assets. As the CDOs themselves are thinly traded, investors may be forced to sell off the more liquid EM bonds, raising the yield on those instruments. Where local currency-denominated EM securities themselves are not very liquid, investors may chose to hedge their overall risk exposure by selling the EM currency short and holding on to the underlying security until maturity. In both cases, the refinancing costs for EM sovereigns rise, although in the latter case the adverse effect on sovereign borrowing costs will be delayed.
There’s already evidence of that happening. In Russia reserves have fallen $6.3bn in the past fortnight as hedge funds shifted their liquid EM assets. And credit spreads – as measured by the JPMorgan Emerging Market Bond Index Global – have risen to 243 basis points from 151bp in June. While that is still historically low compared to the 600-800bp range in 1999-2002, confidence is most certainly on the wane. A significant liquidity stumble from a sovereign could turn current caution to a rout. Say S&P:
Given the prolonged economic imbalances and overheating pressures, especially in the Balkans and the Baltics, the balance of outlooks has now shifted to a prevalence of negative outlooks. Whereas in early 2006 positive outlooks in emerging Europe massively outnumbered negative ones, most positive outlooks have reverted back to stable and currently the outlooks on four sovereigns are negative (the three Baltic countries, plus Ukraine), with only one positive outlook (on the Czech Republic).
According to S&P’s newly-minted Liquidity Vulnerability Index, the most vulnerable countries are Latvia, Iceland, Bulgaria, Turkey and Romania.
Of those, the top three most vulnerable – Latvia, Iceland and Bulgaria – all had sound fiscal surpluses at the last budget. Their vulnerability in the rankings is perhaps proof then, that when it comes to emerging markets, rude economic health does not necessarily inoculate against debt crisis contagion.