(Bloomberg) — The dollar’s rally over the past year has left some emerging markets increasingly vulnerable to capital outflows. The most vulnerable groups began to falter, sending a warning signal to EM as a whole.
In a dollar-based system, countries have dollar liabilities but assets in the local currency. When the US currency appreciates, it eventually puts unbearable pressures on national balance sheets, weighs heavily on the local currency, and fuels inflation pressures and dampens domestic growth. It is only when such countries are in need of capital that high US yields act as a magnet for international flows, sucking capital away from them.
weaker hands. The inability to issue credit in their own currency often leads to the “original sin” of borrowing in hard currency, particularly dollars. Such excesses have become very popular in recent years, with the volume of cross-border dollar credit in emerging markets quadrupling since 2006 to more than $4 trillion.
Capital inflows into emerging markets have been relatively contained so far, but pressure is mounting as US yields hit their highest levels in more than a decade, while the dollar is the strongest in 20 years. This leads to a tightening of global liquidity, which indicates an acceleration of capital inflows into emerging markets.
Reserves are the first line of defense when the capital inflow situation in a country becomes fragile. But not all emerging markets are equally vulnerable.
I have established an external vulnerability measure based on the IMF’s reserve adequacy score. This version has three entries: reserve adequacy in relation to exports, short-term debt (the latter being the Greenspan-Guidotti ratio), and the current account.
This measure placed Turkey, Chile, Hungary and Argentina as the most vulnerable to capital outflows.
However, Turkey and Chile have seen the highest returns on equity so far this year (even in dollar terms).
This may sound paradoxical, but in Chile and especially Turkey, inflation is among the highest and the fastest rising. Stocks are generally seen as an inflation hedge (false assumption, certainly in DM markets) – leading to supportive flows.
This was certainly the case in Turkey where President Erdoğan favored lower interest rates as the response to inflation is now over 80%. With bond yields stuck around the 10% mark, the 100%-150% returns offered in the stock market are almost irresistible.
Now both stock markets are facing upward headwinds. There are country-specific reasons for this – turmoil in Turkish bank stocks, political and social turmoil in Chile.
But both countries face an increasingly unlikely reversal in capital flows, exacerbated by higher energy prices and, in the case of Chile, lower copper prices.
As two YTD positive emerging market equity or DM markets, their recent struggles are a harbinger of other emerging markets, especially those that rely heavily on foreign funding and a stronger dollar.
- Note: Simon White is a Macro Strategist for Bloomberg’s Markets Live blog. The notes he provides are his own and are not intended to be investment advice. For more market commentary, check out the MLIV Blog
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