Special Report EM themes for 2014: From Fragile Five to Thrifty Three

by **Cals** Thu 02 Jan 2014, 09:58

Special Report EM themes for 2014: From Fragile Five to Thrifty Three

Business & Markets 2013

Written by A report by Schroders

Thursday, 02 January 2014 09:47

WE take a look at some of the key themes for emerging markets (EM) in 2014: the export recovery, tapering and the risk of a downturn in Japan. We identify a new EM group, the “Thrifty Three”, as a contrast to the “Fragile Five”, who seem well positioned to take advantage of the export recovery and weather the tapering storm. The three are at risk, however, from Japanese policymakers.

Export and equity recovery?

As we have mentioned previously, there is some evidence that an export recovery is underway in at least some parts of EM. This is to be expected given the ongoing recovery in developed markets (Chart 1). We also made the point that some countries would benefit more than others, with US and EU focused exporters likely to see a better export performance than those trading with Japan and China.

The Japan story is explored further below where we go into more detail on the investment implications of an export recovery. It turns out that there is a pretty strong link between exports and equity performance in emerging markets (Chart 2).

However, it should be possible to do better than simply buying MSCI EM, by instead focusing on export oriented equity indices. We look at a number of EM markets and attempt to assess those for whom this relationship is strongest based on three metrics:

• World exports versus equity market performance; we need equity markets showing a strong relationship with global trade;

• EPS versus exports; export oriented equity indices should see a boost to earnings from export growth; and

• Trade partner performance versus exports; we also need a link between a developed market recovery and EM exports. To capture this, we construct a trade weighted PMI for each EM country, based on a “Big 4” of China, Japan, the US, and the EU.

The countries to perform most strongly across these metrics are South Korea, Taiwan and the Philippines.

Some might be surprised that Mexico did not make the list, but this is largely due to the composition of the Mexican index. The MSCI Mexico index, for example, is very domestically oriented, with the bulk made up of consumer staples, telecommunications and financials. Of course, we still need to consider the impact of tapering.

What could tapering mean for EM?

Larger and sooner than expected, tapering began with not a bang but a whimper, as strong forward guidance soothed investors. Across EM, the response was not uniform — some equity markets rose while some fell, while currencies weakened and bond yields rose slightly across most of EM.

Compared to May and June, EM assets have thrown much less of a taper tantrum. Still, investors should not get complacent. We think the “Fragile Five” and some other EM economies still have problems, and identify a second group, the “Thrifty Three”, as looking most resilient to the changes in Fed policy.
The initial calm does not mean the gradual withdrawal of liquidity won’t cause any problems. A number of EM economies remain highly dependent on foreign finance, and will face higher borrowing costs as tapering progresses. Not only that, but there remains the risk of a “sudden stop”, where capital flows to a country halt or even reverse. In the absence of other sources of funding, the activity previously financed by foreign capital must cease. This has been the case in past crises, and results in sharp falls in output, private spending and credit. Economies which did not use the breathing space afforded them by the delay to tapering in September to gradually reduce their current account deficits could regret it if forced to undergo a dramatic cut in 2014.

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Table 1 presents some metrics that help assess those countries most at risk of suffering in a tapering environment. Firstly, the current account deficit; this gap between imports and exports must be financed through borrowing. The larger this deficit, the greater the financing requirement. In a time of easy money, this financing is quite cheap and easy to come by. The problems arise when rates rise, and questions are asked about borrowers’ ability to repay.
Large deficits raise concerns on this front, prompting investors to reduce their exposure to the country concerned. The cost of financing rises as a consequence, hitting economic growth and making the problem worse in something of a vicious spiral.

Adjustment typically comes through currency depreciation, which cheapens exports and pushes up the price of imports, and/or contraction of domestic demand, which reduces imports. When central banks fight the depreciation, the burden is shifted onto the real economy, and growth suffers.

Meanwhile, a fiscal deficit indicates that a government’s expenditure exceeds its income. Large deficits imply a growing debt stock, and as with a large current account deficit, can lead to worries about the borrower’s ability to repay. In the case of fiscal deficits, this can impact sovereign credit ratings and concerns over higher future taxation, dissuading investment flows. This can interact with and worsen the current account deficit.

Table 1 also considers the gross external financing requirement (GEFR), which we calculate as the sum of the current account balance and all external liabilities due in the next 12 months. The GEFR includes short term debt and FX deposits, both of which may not be renewed or rolled over in the event of tighter global liquidity. Countries with a high GEFR as a share of gross domestic product or reserves (which could be used, in extremis, to provide finance), are at greater risk of a “sudden stop”.

The familiar “Fragile Five” all look precariously positioned, on one measure or more. Only India has managed to reduce its current account deficit since September. Thailand and Mexico also look quite vulnerable based on their balance sheet position, though Thailand at least benefits from a good level of reserves relative to its GEFR. As for the rest, Indonesia, India, South Africa and Turkey all look very exposed in the event of a sudden stop, with reserves ratios of barely over 1.

At the other end of the scale, we see a potential “Thrifty Three”, economies which have improved their deficit position and look reasonably well positioned in a world undergoing tapering. South Korea, Taiwan and the Philippines (which was improving both deficits before the typhoon) look like strong candidates for 2014, particularly as all three were also flagged as standing to benefit from export recoveries above.

What if Abenomics fails?

In last month’s Viewpoint, we highlighted a number of risks to our baseline forecast, one of which was a scenario where Abenomics “fails”. In particular, we believe that the value-added tax hike due in the second quarter (2Q) of 2014 could tip the economy back into recession.

This would necessitate even more aggressive action by the Bank of Japan (BoJ), which would step up asset purchases to further weaken the yen.

The Abenomics fails scenario captures the risk of a much greater depreciation than in our baseline scenario, with the yen falling to 130. Assuming that Japanese companies use the fall in the yen to cut prices (rather than just boost profits through higher export revenues), those who compete with Japanese companies will feel a squeeze on their market share.

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There are two trade channels to consider: a weaker yen will reduce Japanese demand for imports, so countries for whom Japan is a large export market will suffer. The second, as already indicated, is the competitive advantage a weaker currency gives Japan. For this, we need to consider competition by industry and by market. Even if Japan and South Korea are both big exporters of electronics, the damage to South Korea will be limited if their firms do not compete in the same geographical markets.
To measure export industry competition, we use the export similarity index. We utilise a similar concept for geographical market competition, and then multiply the two together to give an overall “competition index”. Plotting this against the share of Japan in country exports gives us a picture of EM vulnerability in the event of the failure of Abenomics (Chart 3).

As might be expected, EM Asia is flagged as being most vulnerable, with the Asean countries above average (the dashed lines on the chart) on both measures of vulnerability. The Philippines in particular is revealed as especially vulnerable. At the other end of the scale, Europe, Middle East and African (EMEA) countries look well positioned within EM, while Latin American countries lie somewhere in the middle.

While South Korea and the Philippines seem likely to perform well compared to the rest of EM when considering the export recovery and effects of tapering, Chart 3 flags up a potential risk from Japan.

Given that the consumption tax comes into place in 2Q, and we see a strong Bank of Japan response occurring in 3Q in this scenario, it may be that South Korea, the Philippines and Taiwan (for which data was not available here) will perform well only in the first half of 2014 before beginning to struggle.

However, policymakers in each are likely to take mitigating steps. As Table 1 shows, fiscal deficits are small or even non-existent in all three, and inflation is also low.

This article first appeared in The Edge Financial Daily, on January 02, 2014.