Currencies tumble as markets reprice risk

Country risk is back with a bang.  As currencies plunge across a number of key emerging markets, investors and exporters alike are trying to make sense of which market might be next and if contagion fears are warranted. Turkey, Argentina, South Africa and Indonesia are the most pressing examples of markets reeling under the sting of rapid currency depreciations as market confidence wanes.   So how do we make sense of the current emerging market sell off? And which indicators can help us better understand which markets are the most vulnerable to the swing in global investor appetite and foreign capital reversals?

A prolonged low interest rate environment and the quantitative easing policies of major central banks provided the backdrop for a deluge of investor money into a number of emerging markets. But the situation has now changed: a strong US dollar, higher interest rates and the winding down of quantitative easing is contributing to growing concern that an inflection point has been reached and an emerging market sell off has taken hold.

It is also important to note that emerging markets have been building up their sovereign debt levels at a steady pace since the 2008 global financial crisis thanks to low interest rates and excess liquidity flooding into emerging markets.  According to the Institute of International Finance (IIF), emerging market debt increased from 21 trillion in 2007 to a whopping 63 trillion in 2017!  But against a backdrop of simmering trade tensions among key global players and rising interest rates, a number of emerging markets are feeling the pinch of a ballooning debt burden, weakening market confidence and the risk of capital flow reversals. 

However, amid all the background noise, it is important to note that while some markets are vulnerable, others remain resilient.  Understanding which markets are vulnerable to capital flow reversals is something we have been tracking. Using key ratios, described below, as well as country risk analyst expertise, some of the vulnerability metrics that we focus on include: 

Real credit growth measures bank credit growth to the private sector and helps us to understand where there may be a buildup of excessive credit growth.  This in turn could lead to imbalances for the banking sector and private sector balance sheets, raising the risk of capital flow reversals. Similarly, portfolio investment liabilities help us to understand “hot money” flows into the financial system. 

An understanding of the scale of the country’s current account deficit to GDP speaks to the market’s external vulnerabilities as this could aggravate currency depreciation leading to external financing challenges.  Import cover is also key as it provides the months of imports that would be covered by international reserves.

Two other key ratios include share of short-term external debt relative to international reserves. given that excessive credit growth fueled by hot money inflows can produce balance sheet imbalances in the currency composition of debt, and the market’s gross external financing requirements (as a percent of GDP) which looks at the sum of the current account deficit, the amortization of medium and long-term total external debt, and short-term total external debt.

So based on these ratios and our subject matter expertise, which are our Top 5 markets to watch? 

1. Turkey has topped our list for some time prior to current events given a significant current account deficit and heavy borrowing in USD/Euro terms by banks and corporates in the country
2. Argentina’s fiscal policies and potential early disbursement from the IMF stabilized the currency, but the currency remains under pressure and inflation levels are high
3. South Africa has significant short-term debt relative to international reserves and has seen currency depreciation stemming from the Turkish currency crisis and rising risk aversion towards emerging markets 
4. Pakistan has high levels of short-term external debt to reserves and faces ongoing currency depreciation and political uncertainty
5. Egypt is vulnerable owing to a high interest to revenue ratio and its reliance on an IMF program which expires in 2019

As markets reprice inflation and interest rate risk, we will very likely continue to see increased volatility across emerging markets given the vulnerabilities cited above.  Better understanding which markets are most exposed to these types of risk can help to provide investors and exporters the type of information they need for sound risk analysis of when and where to do business.   Find out more and stay on top of over 100 markets by following our Country Risk Quarterly.