Emerging Market Central Banks Face Toughest Test

Emerging market central banks are facing their stiffest test since the 2013 taper tantrum. Investors are increasingly betting the US Federal Reserve will keep raising interest rates into 2019, sending the dollar soaring against most developing-nation currencies in the past month.

Debt sales from countries such as Russia and Argentina have been cancelled or postponed recently as potential buyers—becoming suddenly more selective and demanding as US benchmark rates rise—balked at the prospect of faster inflation and widening budget deficits, Bloomberg reported.

Policymakers have started to act, with Argentina’s central bank abruptly raising rates three times, to 40%, to stem a sell-off in the peso. Russia has put the brakes on further monetary easing. Turkey is seeking to bring down its current account deficit, and Indonesia is burning reserves to prop up its currency.

That pressure is being amplified by a surge in dollar debt across the world’s developing economies, which rose 10% in the year to the end of 2017—led by a 22% rise in the issuance of international debt securities—according to the Bank for International Settlements. A fifth of emerging markets and middle-income countries have debt levels above 70% of GDP, led by Brazil at 84% and India at 70.2%, according to the IMF.

"There’s a lot of leverage that has built up in emerging markets," Raghuram Rajan, a University of Chicago professor who previously led the Reserve Bank of India, said in an interview on Bloomberg Television.

A speech by federal reserve chairman, Jerome Powell, on Tuesday in Zurich could set the tone for the next swing in markets. A hawkish outlook could push treasury yields higher and threaten to suck capital away from emerging economies. Higher treasury yields—which hit a four-year high of 3% last month—would pressure local currencies and lure away foreign investors. The International Monetary Fund warned last month that risks to global financial stability have increased over the past six months.

"Central banks may have to respond with interest rate hikes if the sell-off intensifies," said Chua Hak Bin, a senior economist at Maybank Kim Eng Research in Singapore.

Those most vulnerable include Ukraine, China, Argentina, South Africa and Turkey according to the Institute for International Finance.

Stronger Footing

Still, the world economy’s best performance in seven years has boosted trade and capital flows, which in turn bolstered current accounts and international reserves. Foreign currency holdings among emerging market and developing economies are projected to be $144 billion higher this year, according to the IMF. At the same time, inflation remains subdued in most economies.

That means overall buffers are stronger today than five years ago, when the fed triggered panic selling by signaling a taper of its massive stimulus program.

"Emerging market fundamentals are in a much better shape," said Chetan Ahya, chief economist and global head of economics at Morgan Stanley based in Hong Kong. "Almost across the board we have seen improvement in inflation, current account balances and most importantly real rate differentials have been quite solid."

Conditions vary country by country. Russia, the Czech Republic, Colombia, Brazil and Philippines are among those that look less at risk, according to the IIF. And alternative tools developed since the last crisis—such as macro-prudential buffers—allow central bankers a broader set of options than just rate hikes.

"It will be more of an eclectic response," said Robert Subbaraman, Singapore-based head of emerging markets economics at Nomura Holding.

In Brazil for example, after the real traded at near a two-year low, the central bank opted to “smooth out currency moves” by boosting the supply of currency swaps—derivatives that provide investors with protection against losses in the currency—which in turn helped reduce demand for dollars.

Liquidity Conditions

Few central banks have been tested as harshly as Argentina’s. The bank was forced to raise its key interest rate by a staggering 1,275 basis points to 40% in eight days to help stem a near collapse in the nation’s currency. The peso is down 15% this year.

The rate hikes, coupled with the announcement of tighter fiscal targets, were steps in the right direction, but the peso will remain vulnerable to dollar strength, said Jorge Mariscal, emerging markets chief investment officer at UBS Global Wealth Management.

"Liquidity conditions are contracting, and this exposes countries that are vulnerable, where the fiscal situation or current account balance isn’t comfortable," he said.

The carnage in Buenos Aires was a reminder that emerging market policymakers cannot afford to put one foot wrong in a year like this one. In an environment like this, even one misstep—such as a losing inflation target—can trigger an outflow of hot money.

In Turkey a widening current account deficit and consumer inflation near a record high has fueled expectations for higher borrowing costs. Central Bank Governor Murat Cetinkaya has already tightened monetary policy with a 75-basis-point rate hike this year.

Russia’s central bank is no longer signaling it will lower interest rates further. Indonesia has heavily intervened by selling down record foreign reserves holdings to support the rupiah and has warned interest rates may need to go higher. Others, including India and the Philippines, are vulnerable.

In emerging Asia for example, overall investor flows, including into stocks and bonds, are at the slowest pace since 2014, according to Bank of America Merrill Lynch.

"In the short term there’s few options" for central banks, said Mariscal. “The only one that has historically worked is an interest rate increase, and later a fiscal adjustment."