This article first appeared in Forum, The Edge Malaysia Weekly on October 15, 2018 - October 21, 2018

Emerging economies have faced a perfect storm in the past few months, and things are going to get worse. Currencies and asset prices have plunged, with Argentina and Turkey worst hit, but many other emerging economies are suffering collateral damage, even those whose policy and economic fundamentals have been good. There seem to be many causes for the difficulties the emerging economies are facing. Countries with external deficits have suffered the most, but political concerns have also escalated, especially in the Middle East and Venezuela. Both the International Monetary Fund and the World Bank have downgraded global growth prospects, while the IMF has also warned about rising risks of financial stresses. If this was not enough, oil prices have also spiked up.

What are the underlying forces causing the turmoil in emerging economies, will the troubles deepen, and how will our own region be impacted?

The deeper cause: tightening global financial conditions

Ten years of ultra-low interest rates and substantial liquidity injections encouraged substantial flows of capital into emerging economies. Their governments and companies borrowed heavily, quite often in US dollar-denominated loans. Money flowed into their bonds and equities as large global funds sought yields that were extraordinarily low in the developed economies in the wake of the global financial crisis.

But, now, financial conditions are beginning to tighten as central banks, led by the US Federal Reserve, start raising rates and reversing their quantitative easing policies that had injected much liquidity into financial systems. More­over, as the world economy gathered momentum from the middle of last year, more of the available liquidity began to be absorbed by the real economy, leaving less excess liquidity to flow into financial assets. As liquidity became scarcer, investors began to be much more rigorous in how they assess their capital allocation — in particular, they started to re-evaluate their positions in riskier asset classes such as emerging market bonds and equities. With every shift in market expectations in the direction of expecting even more monetary tightening, this re-evaluation intensified and precipitated ever more withdrawals of capital from emerging markets.

Barring a major shock, global financial conditions will tighten further, which means that this reflux of capital out of emerging markets into safer developed markets will get worse. This is particularly the case in the US, where the economy is continuing to grow so much above its trend rate that the risks to inflation and financial stability will rise unless interest rates are raised appropriately. The latest data in the US — the Conference Board and Organisation for Economic Co-operation and Development lead indicators, the unemployment rate and other job market dynamics and business intentions to hire and invest — all point to strong growth continuing for a while. Higher US rates and the resulting strong US dollar will pressure emerging economies further.

Why things will get worse

As global investors get warier of risks, global risks are escalating, with emerging economies likely to be big losers. The clouds are darkening around almost all the major determinants of emerging economies’ outlook.

First, geopolitical risks that affect emerging economies are worsening. In Brazil, a controversial right-wing candidate has emerged as the favourite to win the presidential election. In Mexico, a new president with a radical agenda will take office on Dec 1. These new leaders are likely to create considerable uncertainty in the two countries that dominate Latin America.

Of more direct impact to Asia is US-China ties. It is now clear, from statements made by US President Donald Trump, Vice-President Mike Pence and other senior trade and national security officials of the country that the US spat with China goes beyond just trade. At best, there might be occasional improvements in the relationship when high-level talks are arranged, but that will not change the basic reality, that the US and China are now in a strategic confrontation that will last a long time. China’s Asian neighbours are at the coal face of this trend — they will be pressed to choose sides, will endure growing big power military activities in their backyards and will have to divert more resources from economic development to building up their defences.

But it is in the Middle East where the risks to emerging Asia are potentially the least appreciated:

• Further US sanctions against Iran take effect in early November, forcing Asian countries that import oil from Iran, such as China and India, to look for alternative sources — or face US wrath for defying its sanctions. But it could be even worse. As its economy wilts under these sanctions, some elements in Iran may well feel they have to hit back against US allies in their neighbourhood. Or they may follow up on their threat, made explicitly a month ago, to restrict shipping through the Straits of Hormuz, which would cause oil prices to shoot up, since about a third of the world’s traded oil passes through those waters. Iran’s allies such as the Hezbollah in Lebanon and Syria, the Hamas in the Palestinian territories and the Houthi rebels in Yemen could also step up activities in those flash points as well.

• There are other hotspots in the Middle East where the temperatures are rising. Turkish media have charged that a prominent Saudi Arabian dissident, Jamal Khashoggi, who went missing after visiting the Saudi consulate in Istanbul, has been murdered by unknown parties in the consulate, something which Saudi officials have vehemently denied. Although Turkish President Recep Tayyip Erdogan has been more circumspect in his statement on the issue, there was a hard edge to his comments. Relations between Turkey and Saudi Arabia, already poor, could well worsen. Moreover, there will now be all manner of speculation, such as that this bizarre incident could reflect internal tensions within the ruling Saudi elite, since Khashoggi is a member of that elite. As Khashoggi is well regarded by influential friends in the US and Europe as well as Turkey, there will be serious ramifications for Saudi Arabia if the issue is not quickly resolved.

In short, Middle East risks are rising, and that will surely push oil prices up further into a range that will hurt Asian economies — particularly, India and Indonesia.

Second, China looms large over emerging economies, since it is often their biggest trading partner, a large investor, a huge source of tourism, and its voracious demand for raw materials makes it the main factor in commodity prices. Moreover, at a time when emerging market currencies are under pressure, the last thing they need is for markets to expect a depreciation of the renminbi.

There are clear signs that the Chinese economy is slowing as growth in capital spending eases to its slowest pace in at least two decades. Export growth will also suffer as trade tensions worsen. More than that, reports of production relocation out of China are growing by the day, as producers fear that US tariffs will make it too risky to manufacture in China. Since there are 100,000 Taiwanese companies with operations in China, it would take only a small proportion of these firms deciding to relocate to cause some dislocation to supply chains across Asia and to economic growth in China itself.

Chinese policymakers are mounting a vigorous response — cutting taxes, boosting spending on infrastructure and social housing and injecting liquidity into the economy while also easing policy restrictions such as on the amount of debt state entities are allowed to take and environmental rules. Economic growth can thus probably be sustained at around 6% a year — but at a cost. For instance, if credit policies are eased, then there will be an impact on the renminbi — not so much because the authorities deliberately sought to depreciate it, but as a consequence of their easier monetary policies. Another cost of policy is that pushing up investment could result in an even weaker current account balance. This matters because China has recently shifted from massive current account surpluses to a small deficit in the first half of this year. If the current account balance remains weak, the renminbi would come under even more pressure. If the renminbi, currently trading at around 6.92 to the US dollar, weakens beyond 7, there will be wild movements in currency markets that will hurt emerging market currencies disproportionately.

Which countries in the region are more vulnerable?

Countries that run current account deficits that are funded by debt rather than by foreign investment are more exposed, as are those where foreign ownership of debt and equity securities is large. Malaysia, Thailand, Vietnam and Singapore run surpluses while the Philippines’ deficit is small, so these countries are less at risk.

That suggests that India and Indonesia, which run large deficits that might swell if oil prices surge, are more at risk. But there are other factors that mitigate the outlook for these two giants:

• In India’s case, its capital account is relatively closed, which helps reduce the risks for India. India is also lucky in having a huge base of millions of non-resident Indians, who have been prepared in the past to put large amounts of US dollars into government special bonds issued by the government during periods of external stresses. The Reserve Bank of India is also seen as an effective central bank. What could go wrong in India’s case is if the current travails in its non-bank financial institutions worsen. One major such institution defaulted recently, raising concerns among investors. However, the RBI has managed to stabilise confidence by stepping in with vigorous policy support. Another risk is the electoral cycle — a general election is due in April next year with Prime Minister Narendra Modi under attack over rising fuel prices, the weaker rupee and opposition allegations of corruption over a large defence deal. It looks like Modi will face a tougher-than-expected election battle, but so long as his opponents are unable to unify against him, it is still his election to lose.

• Indonesia may be in a better position. There is an inordinately high foreign ownership of bonds in the country, which means that maintaining the confidence of foreign investors is vital. So far, this confidence has been supported by political and policy developments. President Joko Widodo is expected to coast to an easy victory in next year’s presidential election, thereby ensuring continuity. He has also empowered the technocrats in his government to fashion a solid policy response to the pressures on the rupiah. Bank Indonesia has raised policy rates boldly, while the government has announced a series of measures to reduce imports, boost exports and attract more foreign capital while also making technical changes to allow more hedging that would reduce the demand for US dollars. So long as sound policymaking continues, the slide in the rupiah can be managed.

Conclusion

Turbulence in financial markets is likely to worsen, and emerging markets will bear the brunt of that turbulence. Asian emerging economies cannot escape these stresses, but their better policy management and good economic fundamentals should allow them to weather the storm.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

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