BNY Mellon: Emerging Pressures

Oct 16, 2018

By Neil Mellor, Senior Currency Strategist, BNY Mellon

Emerging markets have been here before: last week’s 4.6% drop in the KOSPI, for example, would not even make the top 50 declines recorded since the turn of the millennium. But irrespective of any near-term stability, the pressures on emerging markets are set to continue growing nonetheless.

We have argued that the most immediate risk facing emerging market investors, in particular, is a weakening in the CNY below 7 to the USD.

Of course, oil prices could be about to feature as an equally prominent risk - a complement to ‘trade war’ uncertainty which is chipping away at growth.

But one of the more fundamental problems facing emerging markets is the ongoing divergence between US interest rates and those elsewhere across the globe.

Whilst the Fed has raised rates eight times since 2015, few of its peers, even now, are yet in a position to contemplate their first hike.

More fundamentally, rising US rates continue to pressure USD liquidity and those nations particularly exposed to USD-denominated loans.

The BIS tells us that USD credit to non-bank borrowers outside the US rose to $11.5 trn by the end of March 2018 – a rise of 7% year over year – of which one third made its way into emerging markets.

We mention this because three-month USD Libor has resumed its uptrend. This rate – a benchmark used to price a vast nexus of financial contracts around the world – climbed from under 0.5% in early 2015 to 2.3% by the end of March. It was then broadly unchanged through the start of last month, but has since risen a further 11 bps.

Clearly, even if the Fed were only able to implement a portion of its plans for tightening over the next 18 months, pressure on funding is only going to grow with negative repercussions for the credit structure across the emerging markets.

Worse, for some in the sector, currency considerations may oblige policy rates that are increasingly unsuited to domestic fundamentals.

In other words, as currency moves have necessarily become a bigger element in the equation of price stability, it is easy to envisage central banks implementing policies that encourage a divergence in the price of goods of external and domestic origin, presumably to the detriment of growth.

For the most part – and certainly in South East Asia – inflation is not yet a problem in the emerging sector