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The Daunting Challenges Emerging Markets Are Facing

Recently, the exchange rates of Indonesian Rupiah and Malaysia Ringgit have fallen to 17-year lows against the US dollar, approaching the historical lows recorded during the Asian Financial Crisis in 1997-98. And Indian Rupee is also trading not far from its historical low recorded in 2013. Along with plunge in their stock markets, concerns are heightened that another financial crisis is brewing in emerging markets.

Emerging markets already in limbo

But before this year, cracks already appeared in emerging markets’ armor. BRICS, as the world’s five largest emerging markets located in Asia, Europe, South America and Africa, were already in crisis or succumbed to weakness. Hurt by oil price’s plunge of 60% in 2014 and sanctions by the US and Europe, Russia had been in crisis mode since end 2014. During the first two quarters of this year, Russia’s GDP was down by 2.3% and 4.6% from the same period a year ago. The IMF forecasts a 3.5% contraction for the Russian economy this year as a whole. Its inflation in July was 15.6%. And the Russian Ruble depreciated against the dollar by 46% in 2014, followed by another 14% this year to 70 Rubles per US dollar, not far from the record low of 79 Rubles at end 2014. As oil price revisited the $40 a barrel threshold recently, Russia’s situation is nowhere near easing. Thankfully, its impacts are local, without triggering domino effects in emerging markets. Affected by similar plunge in commodities prices of about 40% in 2014 as measured by the CRB Index, Brazilian Real and South Africa Rand depreciated against the US dollar by 34% and 21% since 2014. For the first two quarters of this year, the Brazilian economy contracted by 1.6% and 1.6% respectively. With inflation as high as 9.6% and recurring current account and fiscal deficits, Brazil has been struggling even without unexpected external shocks.

In China’s case, its economic fundamentals are among the strongest in BRICS. Its low inflation, current account surplus, low fiscal deficit, low external debt, high foreign exchange reserves, etc., are the envy of other emerging markets. However, slowing growth, plunging stock market, and the RMB’s depreciation against the dollar constitute new uncertainties home and abroad. According to the IMF’s latest forecast, India may register faster growth than China this year. Yet India is plagued by higher inflation (5.3% the latest) and twin deficits, with its fiscal deficit faring worse, rendering it more vulnerable to sizable capital outflows. Between end 2013 and beginning 2014, India and Indonesia were major concerns as the US rate hike loomed and subsequent fall feared. The pressure was off only after the US held rates unchanged later on. Nevertheless, the problem was only delayed, not solved. The Indian Rupee is trading at half of its pre Asian Financial Crisis level, and only about 4% from its historical low recorded in late 2013. A lot of bad news is being priced in.

The now and then of Asian emerging markets

The Asian emerging markets are all experiencing currency devaluation and stock market correction of late. But the similarities to Asian Financial Crisis stop at the surface. The Asian Financial Crisis was first a debt crisis. Borrowing large amounts of US dollar debt, substantial currency and maturity mismatch occurred when the dollar strengthened and capitals flew out, resulting in a debt crisis. It was then followed by a currency crisis. Under concentrated speculative attacks, Southeastern countries abandoned their fixed exchange rates to the US dollar one by one, resulting in plunge in exchange rates. Eventually, an economic crisis broke out. Unsustainable external debts in US dollars, sizable current account deficits, and rigid exchange rate mechanisms were to blame.

As of now, besides rebuilding sizable foreign exchange reserves, Asian emerging markets all command much better economic fundamentals than before. In terms of external debt, Malaysia is the only country with high external debt to GDP ratio (65%), which helps explain why the Malaysian Ringgit is weak. For others, the external debt ratios are between 22% and 38%. Combined with efforts to develop local currency bond markets, a debt crisis seems unlikely even under the same scenario of dollar strength and capital outflows. With the exceptions of India and Indonesia whose ten year sovereign yields at 7.8% and 8.9% respectively due to higher inflation, other Asian emerging markets’ yields stand between 3% and 4%, with Thailand’s benchmark sovereign yield as low as 2.8%. And their five year CDS spread stand between 100 and 200 basis points, less than Brazil and Russia’s 345 and 421 basis points, suggesting little risk of a debt crisis.

In terms of current account, with the exceptions of India and Indonesia in mild deficits of 1.4% and 3.0% in 2014, other Asian emerging markets are all in surplus between 2.1% and 5.5% of their respective GDP according to the IMF’s projections. Hence, they do not need to rely on inflows to finance their current account deficits, reducing the risks associated with strong dollar and capital outflows.

Another defense mechanism currently at work is the floating exchange rates. The mistake of defending fixed exchange rates until running out of foreign exchange reserves is not repeated by Asian emerging markets. Even though Indonesia, Malaysia and India’s currencies are approaching their record low, it is driven mainly by market force, instead of uncontrolled collapse as the result of speculative attacks. In this case, the risk of triggering debt crisis and economic crisis is subdued. Prior to the outbreak of Asian Financial Crisis, the exchange rates of Thai Baht, Indonesian Rupiah, Malaysian Ringgit and Philipino Peso were all flat or at very narrow trading range against the US dollar, suggesting foreign exchange intervention to support the exchange rates. Later when Thai Baht gave up first because of the depletion of foreign exchange reserves, they succumbed to devaluation of more than 50% in few months, with Indonesian Rupiah devaluating by more than 80%.

But this time around, their exchange rates have been floating for 17 years. And since the US subprime crisis and financial tsunami, they have experienced both ups and downs, appreciating by more than 20% against the dollar in the first few years when the dollar was weak, and depreciating in the last two years when the dollar turned stronger. Although it does not mean their currencies will not make new lows or come under renewed speculative attacks, but floating exchange rates can help absorb a lot of shocks, and alleviate the risks of debt and economic crisis. Moreover, as China’s manufacturing have been relocating to Southeastern Asia for years, weaker exchange rates can help increase the competitiveness of these countries’ manufacturing and exports, as long as the depreciation is not forced or out of control.

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Content provided by Bank of China (Hong Kong)
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