The impact of commodity price, currencies and the Shanghai market’s volatility finally spills into developed countries’ equity markets but the effect was short-lived as NY Federal Reserve President William Dudley said a rate hike was ‘less compelling’ now than several weeks ago. Dudley’s remarks were followed later in the week by Vice Chairman Stanley Fischer who said it was ‘too early to tell’ although there was a ‘pretty strong case’ until recently. With the Fed still in the spotlight, Finance Forward looks at how well a BIS working paper that lays out how a crisis could occur matches up with Turkey as an example and follows the article with a look at the external debt risks in Indonesia.
BIS warns of effect of rising ‘world’ interest rate but some data disagrees
The Bank for International Settlements (BIS) released a working paper timed almost perfectly to the recent volatility which makes the case that developed market yields have a dramatic impact on the long-term yields in emerging markets. The effect of this is that countries with floating rate currencies retain their monetary policy flexibility where rates are set (at the short-end of the yield curve) but the monetary policy is less effective at influencing long-term yields on their own local currency bonds.
In a period where developed markets have maintained low interest rates, the ‘world’ interest rate has been fixed near its zero lower bound (the authors point to the 10-year US Treasuries as “dominat[ing] this ‘world’ interest rate”), the prospects of ‘normalizing’ interest rates represents a significant risk for emerging markets. The mechanism for the risk is that the changes in the ‘world’ interest rate have twice the impact on long-term bond yields in emerging markets as the same change would if made by that country’s central bank to its short-term interest rate target.
The authors argue that the rise in term premium (which has been falling since the early 2000s) could reverse when investors decide the rate tightening cycle is set to begin. If the term premium expands, it would push longer-term interest rates up by more than any immediate rise in the Federal Funds Rate potentially raising emerging market local currency bond yields. The ‘taper tantrum’ in 2013, when investors began to anticipate the end of the Fed’s asset purchases and emerging market bond yields rose, is the model for the beginning of the crisis in emerging market debt markets by the authors’ logic.
The move would be amplified by foreign investors (who now own more than 30% of some emerging market local currency bond markets) pressuring currencies through out-of-the-money FX hedges (bond prices tend to move with currencies). Adding to the pressure would be investors in emerging market local currency bond mutual funds and ETFs taking advantage of their daily or intraday liquidity and forcing sales of the underlying assets which are significantly more illiquid.
The recent volatility, which has been brewing throughout 2015, provides a useful test for the hypothesis of how emerging markets are ‘broken’ as a result of the rise in importance of the ‘world’ interest rate and foreign investors’ liquidity preferences in local currency markets. As an example, consider Turkey which has seen political risk, geopolitical risk as well as the exchange rate volatility associated with many emerging markets this year. It should be a ‘perfect storm’ but at least to date, it has weathered the storm relatively well.
The chart below shows the last 5 years of the Turkish lira exchange rate and spread of local currency bonds maturing in 2025 over 10-year treasuries. Notable are 2011, 2013 and 2015 when the lira lost about one-quarter of its value against the dollar and local currency spreads rose from about 500 basis points (bps) to 800 bps. But the currency stabilized and yields returned to their earlier level. The ‘taper tantrum’ has a similar 25% devaluation in the lira against the dollar with rising spreads again. But again, the currency stabilized (but did not appreciate back to earlier levels) and yields fell.
It is too early to tell whether the cycle will repeat again in 2015/2016, but as a similar 25% devaluation has been accompanied by a rise in spreads from 500bps to 800bps. This could be the ‘beginning of the end’ for emerging markets if the BIS working paper is correct. However, the data fails to show (or show yet) a cycle of rising yields (“foreign investors may react to turbulence by pulling back in an indiscriminate way” creating a “distress loop”), falling currencies (“prices in the more liquid forex market may overshoot“) and fire sales by mutual funds (“run-like flight out of EM assets”).
So far, the movement in the lira and lira-denominated government bonds has been in line with previous cycles of Fed- or ECB-induced fears about interest rate rises. In addition, research from the Investment Company Institute finds that although regulated funds control 30% of foreign-held emerging market debt, they account for just 15% of total volatility. Data from the International Institute of Finance, which tracks emerging market portfolio flows, finds significant outflows from EM equity funds (down $8.7 billion in August), there was a net (albeit lower) inflow for EM debt of $4.2 billion.
Another metric of the distress loop would be the spread of Turkish sovereign bonds denominated in hard currency (USD) over US Treasuries shown in the chart above. If the ‘distress loop’ were beginning, the spreads should be wider today on USD bonds to reflect higher risk of a debt crisis that would result. As the chart shows, not only is this not the case, the rise in spreads on Turkey’s international bonds are lower than in either the 2011 and 2013. Not all the evidence calls for an entirely sanguine outlook—Turkey’s CDS spreads today are wider than following the taper tantrum but the weight of the evidence to date points to current volatility not being indicative of the start of a ‘distress loop’ for emerging markets.
Indonesia’s rough patch
China’s ‘Black Monday’ last week sent tremors around the global as hundreds of billions of dollars were wiped from stock markets both in emerging as well as developed markets. For as much as the current volatility in the global financial markets, falling commodity prices, a decelerating Chinese economy as well as a potential rate hike by the US Federal Reserve has sparked jitters to investors who saw emerging markets as a way to invest in higher growing economies.
Indonesia, an emerging economy, could contain an opportunity for emerging markets investors. Although Indonesia’s economy performed exceptionally well over the decade following the Asian Crisis, its growth has slowed down primarily on the back of weaker international demand and slower investment growth due to lower commodity prices.
Despite a drop in commodity prices, Indonesia recorded a $0.5 billion trade surplus in June 2015, the country’s seventh straight monthly trade surplus. But lower commodity prices do not bode well for Indonesia as it is a major exporter of coal, crude palm oil (CPO), nickel and various other commodities which have plunged recently and show no signs of a rebound any time soon due to lower Chinese demand. Another worry is the depreciation of the Rupiah, which will help preserve Indonesia’s trade surplus (mostly by curbing imports).
However, with export dropping from lower Chinese demand, the current account deficit will remain high due to a drop in exports as well as foreign investor equity inflows reversing as prices drop according to IIF data. With the central bank policy rate already hovering at 7.5% and 10 year bonds yielding 8.71%, a continued sluggish economy and could make Indonesia vulnerable to further currency weakness, stoking a pick-up in inflation from its 5.4% rate in 2014 to a year-over-year 7.3% rate in July 2015.
As of yet, the increase of its government bond spreads over Treasuries is signaling more limited vulnerability compared to markets like Turkey (see article above) though rising international interest rates could expose the government and private sector being dependence on external funding.
The deadly duo–external funding and currency depreciation–could overwhelm what little positive signs there are today and send Indonesia’s economy into a rough patch. External debt outstanding (debt owed to non-residents) was $292.6 billion as of the end of 2014, up 10 percent from $266 billion at the end of 2013. Moreover, the Indonesian rupiah has fallen about 12% so far this year, crossing the psychological barrier of 14,000 per USD. With significant external debt, a drop in the currency represents a rising burden for Indonesia’s Rupiah-earning state and corporates.
With the dollar value of external debt having grown by approximately 30% from 2011 to 2014, the market may be vulnerable to a Fed rate hike. Higher US rates will put further pressure on the Rupiah and the Indonesian economy. In order to avoid further pressure onto the IDR, in such a high inflation environment, Bank Indonesia (BI) (Indonesia’s central bank), may have to raise the interest rate. Although an increase in interest rate will further slow down the economic activity, it might well serve BI’s goal of ensuring a stable financial system, contributing to price stability and defending the Rupiah.