Fed taper not a grave threat to the Fragile Five

But 2014 will see heightened political risk in emerging markets

FOR MANY emerging market investors, 2013 will go down as a year to forget. The MSCI emerging market equity index fell from highs of over 1,055 at the beginning of the year to less than 884 in June, ending the year 5 per cent down at 1,002. The start of 2014 hasn’t seen a new wave of optimism – the index has since retreated to 972. Developing world currencies, meanwhile, fell 1.9 per cent across 2013, according to MSCI.

And with the Federal Reserve beginning to unwind its quantitative easing (QE) programme this month, the risk of capital outflows from the developing world (particularly the so-called fragile five of India, Brazil, Turkey, Indonesia and South Africa) has prompted a relatively downbeat outlook for 2014. JP Morgan, in a year ahead briefing note, said that emerging markets “with current account deficits could face a more challenging time with the Fed unwinding its quantitative easing.”

But some see the danger of capital flight as overstated. And an exclusive focus on liquidity issues ignores that some of this year’s most significant market-moving events in developing markets may stem from politics. With elections due in India, Brazil, Turkey, Indonesia and South Africa, and the possibility of populist political programmes taking hold in reaction to civil unrest, political risk could come to dominate emerging markets in 2014.

“Some are anticipating a large crisis for emerging markets as the Fed winds down QE,” says Ishaq Siddiqi of ETX Capital. Because of their relatively high level of reliance on external financing, India, Indonesia, Brazil, South Africa and Turkey were all hit hard when outgoing Fed chairman Ben Bernanke initially mooted the idea of tapering in 2013.

Between late May and late August, Indian stocks plunged 13 per cent, and Indonesia’s Jakarta Composite index fell by 26 per cent over the same period. The Brazilian real, meanwhile, ended the year just above $0.42 – 13 per cent lower than at the start of 2013 – and the Turkish lira has continued its protracted decline against the dollar (see graph), reaching record lows yesterday. The fear is that an end to QE in 2014 could see a repeat of this, with the currencies and bourses of the more vulnerable emerging markets hit hard.

But this fear is exaggerated, according to Gareth Leather of Capital Economics. “Since the big sell-off in the summer, many of these countries have taken steps to minimise the effects of the Fed’s taper,” he says. India reported a current account deficit of $5.2bn (£3.17bn) between July and September (equal to about 1.2 per cent of GDP), compared to $21bn (5 per cent of GDP) during the same period in 2012. Last month, Indonesia reported a surprise $42m trade surplus for October.

Moreover, Leather points out, rising central bank rates across many of the most vulnerable developing markets should help to suck more capital back into their economies, helping to combat possible capital flight and minimising the consequent market volatility.

This is not to say that the withdrawal of Fed monetary stimulus will be entirely seamless for emerging markets. “Traders are likely to see heightened volatility up to March,” says Siddiqi. The Indonesian rupiah and Indian rupee could come under pressure, for example, with dollar-rupiah likely to rise from its current level of close to IDR12,200. But US monetary normalisation may not be the catastrophe for emerging markets that some fear.

Rather, some of the most important market-moving events of 2014 could stem from the relatively chaotic political situations in the developing world. “With lots of cheap money flying around in the last four or five years, people have tended to ignore some of the underlying features of emerging markets,” says Standard Bank’s head of emerging market research (ex-Africa) Timothy Ash. “These include low GDP per capita and political instability,” he says.

Last summer saw mass protests in Brazil, with widespread anger over the government’s outlay on the hosting of the Confederations Cup football tournament (in addition to this year’s World Cup) at a time when much of the country is still struggling with poverty. According to Siddiqi, “there is a perception that the growing voice of the middle classes in some emerging markets could lead to populist economic policies, rather than much-needed structural reforms.” In reaction to last year’s protests, Brazilian president Dilma Rousseff quickly pledged $23bn of transport investment. Brazilian inflation data (released this Friday) is expected to come in at 5.85 per cent for 2013, and some fear that any populist giveaways would increase upward pressure on prices.

With elections due this year in Brazil, India, Indonesia, South Africa and Turkey, the danger of further measures that threaten government budget stability may be particularly acute. “There is always the risk of a pre-election blowout,” Leather points out.

And elections are not the only potential source of political risk in the year ahead. Ash highlights Turkey’s ongoing governmental turmoil as an example. “The current corruption scandal involving Turkish politicians is pretty sizeable,” he says. “At the moment, the country has a worrying mixture of weak politics and macroeconomic instability.”

But alongside the risk of pre-election giveaways is the possibility of crucial economic reforms. Leather points out that in India and Indonesia, in particular, there are reasons to be hopeful. India’s opposition Bharatiya Janata Party (BJP), led by Narendra Modi, the current chief minister of Gujarat, looks likely to displace the ruling Congress party.

Modi has built a relatively business-friendly reputation in Gujarat, which has grown by over 10.3 per cent since his first full year in charge in 2002, significantly higher than India as a whole. A strong majority for Modi would raise the chances of serious reforms, and most likely go down well with equity markets.

According to Siddiqi, market volatility around the election period could prove a buying opportunity if the results provide clarity regarding the road ahead. “I would advise extreme caution,” he says, “but large multinational companies could provide exposure to emerging markets, with slightly lower risk than some domestic firms. I would steer clear of the Brazilian real for now, though, and Latin American banks look risky.” Even with extremely violent upheavals in the developing world, such as Egypt’s summer coup, stocks have been able to rebound, he points out.