China's unprecedented devaluation of the Yuan last week has sent shock waves throughout global emerging markets, with the PBOC's move being felt most acutely by China's immediate neighbors such as South Korea, Taiwan, and the sprawling economies of Southeast Asia. In a worrying reflection of the Asian currency crisis of the late 1990s, some of the region's more prominent currencies are in free fall. The Malaysian ringgit has weakened nearly 30% against the dollar this year, and an incredible 8% this month alone. The Indonesian Rupiah (IDX) has been under pressure since 2013, cratering 42% against the U.S. Dollar due to collapsing commodity revenue and a ballooning current account deficit.
The implications of these deteriorating currency positions for emerging markets are obvious, and perhaps no better demonstrated by the 10% plunge in the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) this month, bringing the total drop to 28% year on year. The grim news for many of these emerging markets is the economic environment looks set to get far worse in the weeks and months ahead. Many Emerging Markets are heavily dependent on commodity export revenue, manufacturing exports, or both. Nearly all have vastly inflated bubbles in both commercial and residential real estate which are likely to increase NPLs throughout their respective banking sectors. U.S. dollar borrowing by the corporate sector has reached unprecedented levels in many cases, particularly for the financing of capital goods and machinery. Machinery which may very well be mothballed in the months ahead as Chinese manufacturing overcapacity and contracting domestic demand begin to work their way through these economies. The strains of deteriorating currency positions within emerging markets are about to be unleashed, and the fallout could be epic.
Rating Agency Downgrades are in the Past
As plunging export revenues continue to work their way through emerging market economies, there is an increasing likelihood for the broader market to start questioning the solvency of vulnerable corporations and sovereigns. The investment grade seals of approval which were handed out to many emerging market nations over the past five years could start being revoked by the major agencies. Investment grade status was a huge boost to Emerging Markets, and their withdrawal would be a detrimental reflection of the overall health of the world economy. With investment grade status awarded to these nations from the rating agencies, yield starved funds in developed markets poured good capital after bad into these newly rated bonds, pushing yields to record lows, with some nation's 10 year yields falling to the long run historical average of U.S. 10 year treasury bonds. Bonds which had been trading at Junk status before the Lehman crisis were now changing hands as though they were prime. Corporate and private borrowing soared, consumption skyrocketed and asset prices soared. The question going forward, is how resilient emerging markets have been become in the years following the Lehman collapse. How strong a foundation are these gains over the past 7 years build on. If recent evidence is anything to go by, the answer is not reassuring.
Evaporating Liquidity and Narrow Exit Doors
If the entrance door to these markets was welcomed with great fanfare and initial gains, the exit door is proving far less accommodating. The fixed income markets of these countries are shallow, with sporadic liquidity. The spot FX markets are equally opaque, and hedging through the use of forward contracts is notoriously expensive, removing the ability to hedge altogether in many cases. Investors in these markets are swimming unhedged, as FX rates continue to plunge the losses on these bonds will accelerate and without the ability to sell in any meaningful size, attention will turn to the equity market. The overhang on Emerging Market equity markets as a result of illiquid bond markets cannot be overlooked. Many of the global funds parked in Emerging Market fixed income are also whales in the equity space, often dominating the top 5 holders of the prominent blue chip companies. Domestic pension funds will also be forced sellers in the equity markets to meet redemption requests which they cannot raise from their trapped bond holdings. This wall of entrenched selling is the reality facing investors in the emerging market space for the foreseeable future and current entry into these markets looks premature at best.
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