لخّصلي

As if the global trade tensions, commodity volatility and US rate normalization was not enough, emerging markets are staring at a potentially destabilizing reckoning.

While inflation in BRICS countries (proxy for emerging markets) is declining or stable - that of developed markets is inching up faster than expected. The evolving situation will disrupt the ongoing fiscal consolidations across the emerging market space and batter its asset classes if experts remain less vigilant. The countries, which were running high inflationary pressures in the recent past are experiencing a period of relative stability despite increasing crude prices. However, developed market interest rate normalization is occurring faster, given rising inflationary trends – creating volatility.

One look at the numbers explains the situation profoundly. From a peak of 9.25% recorded in 2015, emerging market interest rates declined to 6.25% on average by calendar year 2018. Developed market interest rates however increased to 0.75% during the same time, compared to just 0.25% earlier. This is reducing interest rate differential between ‘safe haven’ developed markets and ‘risky’ emerging markets, theoretically dangerous at a time when global capital begins its westward migration.

With these events unraveling in the background, the emerging markets are stuck between a hard place and a rock. This is because they have to tread a very thin line between domestic macroeconomic stability and catching up with rising developed markets interest rates, which have implication not only on their exchange rates but also their financial asset valuations.

Historically, the emerging markets dream run is associated with the continued inflows of the so called hot money during and since the Quantitative Easing. These countries are therefore regarded as high return havens, given their high economic growth and comparatively higher interest rates. This status however also makes them vulnerable to sudden changes in global liquidity, triggered by the world’s prominent central banks, primarily the Federal Reserve.

Since none of the emerging markets have the highest rated benchmark sovereign debt - their asset classes are deemed riskier compared to those of the so called developed markets. Therefore, as soon as interest rates go up in the US, EU or Japan, invested money in emerging markets financial assets loses its sense of permanence and panic ensues. The term ‘Taper Tantrums’ is often used to describe this very situation and the recent emerging market rout is proof of its lingering existence.

The purpose of establishing the dollar swap lines among six structurally important central banks, under Section 14 of the Federal Reserve Act was to stabilize the global market. The idea was to establish a global liquidity framework that would allow the world’s key central banks to maintain sanity during volatile times. Post the 2008 financial crises, the arrangement allowed the identified member central banks (namely, the ECB, Bank of Japan, Bank of Canada, Bank of England and the Swiss Central Bank) to borrow dollar from the US Fed and stabilize not only their own economies but dependent regional economies as well.

What actually happened however ignored the so called dependent economies and created a sanctuary of the big boys. While these dependent economies, popularly known as EMs were left to the vagaries of an appreciating dollar, the protected nations ensconced themselves from the liquidity crises considerably. Moreover, countries in the protected group are developed economies (DM) and maintain mature supply chains, keeping price pressures at bay. Apart from Japan and Switzerland, most countries in the grouping even had access to significant domestic energy production, which was acting as a continuing stabilizer. This created a comfortable position for most developed markets with inflation remaining lower than the 2% target for the most part. The emerging markets on the other hand, even though had access to energy reserves themselves, were dealing with inefficient supply chains and supply-demand mismatches (accentuated by their depreciating currencies), creating inflationary pressures until January 2016, when the Iranian sanctions were lifted.

The event was one of the most significant macroeconomic events for these emerging markets, given the consequent impact on their current account and fiscal deficit. As anticipated, tampering with Iran oil supplies had far reaching ramifications on oil importing emerging markets, which reckoned the commodity key to their stability and fuel to their economic expansion. With sanctions lifted, January 2016 onwards, oil prices began to ease, falling below the $50 per barrel mark.

Resultantly, most emerging markets started to recover and inflationary pressures started to ease. Explaining the implications, the average inflation in BRICS countries came down to 5.7% in calendar year 2016 from nearly 7.3% the previous year. This stabilized further to 3.7% in calendar year 2017 as supplies replenished the system. However, as the fear of sanctions returned, the futures market factored in the risks and inflationary pressures returned. Nevertheless, emerging markets have not been impacted as much and inflation remained under control, rising by just 30 bps in calendar year 2018, as on September. This is because food prices remain soft and so does prices of daily use consumer items, in affect neutralizing the oil price spurt.

Developed markets on the other hand are operating on a different level; macroeconomic recovery has caused inflation to breach the benchmark 2% level. While this number is still not characterized by inflationary pressures, it warranted increase in interest rates among these rich countries. Again, the numbers do the talking here as well. Inflation in developed markets increased to 0.5% on average in calendar year 2016 from just 0.2% the previous year. This further increased to 1.7% in calendar year 2017, breaching 2% in calendar year 2018, as on September.

This is potentially a destabilizing situation, especially for the hapless emerging markets as developed markets interest rates have started or anticipated to rise further. The first signals are emanating from the American Federal Reserve, as stability ensues in the world’s largest economy. The widespread effects of the US Federal Open Market Committee (FOMC) on global interest rates are already visible. While the Bank of England had already increased rates on the lines of its American counterpart, the European Central Bank hints (ECB) of doing the same in the near term as it puts a stop to its asset buying program. An event, which will expedite emerging markets capital outflows and threatens their asset classes.

Therefore, it’s time for a reality check for those considering the robustness of the emerging markets growth story. As normalization in the rich world will not stop and frankly wouldn’t provision for risks to emerging markets, the invigorating flows of global capital will be suddenly emaciated. Given these insecurities looming in the background, it’s time to sit back and introspect. Apart from that, there is very little anyone can do to contain the situation at this time, given the state of current affairs.