During 2017, the combination of strong growth in the global economy’s major centres of activity — China, the euro area, and the US — and accommodative financial conditions buoyed EM assets. The benchmark MSCI EM index rose 34%, aided by a weakening US dollar and broadly flat long-term US interest rates. 2018 has not been as easy a ride. Global GDP growth remains resilient, albeit with a change in its composition. Softening in China and Europe is largely being offset by strength in the US. While global GDP growth this year is likely to check in at close to last year’s level, financial developments in the US have weighed on EM sentiment, and the MSCI EM index has shed around 10% of its value.
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The US dollar has appreciated by 8% against EM currencies this year, compared to a more modest 2% gain against other majors, such as the euro, which are less prone to sudden changes in sentiment. Strength in the US dollar at the beginning of the year mostly reflected expectations for stronger growth and faster interest rate normalisation. The latter helped to drive a 60 basis points increase in the yield on a ten-year US Treasury. Sentiment towards EMs then seemed to suffer from Sino–US trade tensions. The renminbi shed 7.5% of its value against the US dollar from the beginning of June to the middle of August, as both sides implemented tariffs and threatened more. That depreciation was larger than even our own pessimistic forecast. It seemed to reflect in part attempts by authorities in Beijing to offset the impact of US tariffs. The impact rippled through to other EM economies, with most of the decline in the MSCI EM occurring during this summer period.
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While the US dollar has appreciated versus most EM currencies this year, it has gained the most against currencies from economies with weak fundamentals. The chart below shows a range in the real effective exchange rate performance of 14 EM economies. Those with bad fundamentals, based on their twin deficit position (sum of budget and current account balances), have tended to experience large depreciations. This has been most acute with regards to Argentina and Turkey, but can also be seen in Brazil, India and Indonesia. Meanwhile, economies with more balanced positions such as Malaysia, South Korea and Thailand have weathered the storm better. To paraphrase Warren Buffett, the tide is going out and investors are starting to worry about which EM economies have been swimming naked.
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The adjustment seen in emerging economies this year reflects a re-pricing of risk following a period of artificial calm due to easy global financial conditions. For most, the impact will be slightly softer GDP growth next year, due to the lagged impact from higher interest rates. However, those with severe imbalances, such as Argentina and Turkey, will face significant macroeconomic adjustment costs and experience outright economic contraction. Other potential candidates for more severe readjustments are large twin deficit economies such as Brazil and Indonesia. Risks to the former are being compounded by uncertainty ahead of upcoming presidential elections. Nonetheless, the risk of a widespread crisis across EMs remains low.
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