EMEA Emerging Economies: Diverging Trends In Volatile External Conditions

External financing conditions in emerging economies remain highly volatile, as foreign investors repeatedly reassess the attractiveness of emerging market assets in light of ever-changing expectations about the path for interest rates in the U.S. and other advanced economies.

This frequent reevaluation has resulted in the ebb and flow of global capital to emerging-market countries over recent years, spurring volatility in their currency, bond, and equity markets.

A Volatile External Backdrop For Emerging Markets
In the aftermath of the U.S. election, emerging market assets took a dive because markets were quick to assume that a meaningful fiscal stimulus in the world’s largest advanced economy was on the cards, in the form of tax cuts and higher infrastructure spending. This narrative implied higher growth and inflation in the country, and therefore, a steeper path for U.S. rates, making emerging market assets relatively less attractive. U.S. bond yields jumped, while European rates also saw a rise. As global financial conditions began to tighten, a wave of portfolio outflows from emerging markets globally ensued. This effect, dubbed the “Trump tantrum,” wiped out $26 billion of foreign capital from emerging market debt, and $4 billion from equities in November 2016, according to estimates by the Institute for International Finance (IIF) (chart 1).

This looks like an overreaction, given the uncertainty about the size and timing of the actual fiscal stimulus in the U.S.
As bond yields in advanced economies eased from post-election highs, it didn’t take long for international investors to readjust their views and to return to emerging markets. Over December-February, net foreign debt flows into emerging economies amounted to $29 billion and equity flows $14 billion (chart 1), based on the preliminary estimates from the IIF. The IIF also reports that those emerging economies for which daily estimates are available have so far attracted $5.4 billion of portfolio flows in March. Emerging market equity prices suffered losses in the first few days after the election, with the MSCI Emerging Markets Index down 7%, but have since recovered strongly, exceeding the pre-election level by 8% (chart 2).

Against a global backdrop of gradually tightening financial conditions, we think that capital flows to emerging markets will be subdued in 2017, while remaining volatile. We see two drivers of this volatility. First, monetary policies across major developed markets are still diverging. The U.S. Federal Reserve is firmly on a tightening path: The rate-setting Federal Open Market Committee raised the Federal funds rate by 25 basis points (bps) on March 15, to the target range of 0.75%-1.00%. This is the second hike in three months, and we expect two more hikes this year. At the same time, the European Central Bank (ECB) is still in Quantitative Easing mode, and will continue to expand its balance sheet for quite a while, in our view, even if the monthly amount of assets it purchases will decline gradually, starting from April 2017. We think it is unlikely that the ECB would start hiking its main policy rate before 2019. Meanwhile, we expect the Bank of England’s monetary policy to remain accommodative, after the introduction of a new set of easing measures following the Brexit vote last year.
Secondly, uncertainties persist about the magnitude and timing of fiscal measures in the U.S. As unemployment in the U.S. has fallen close to pre-crisis levels, higher fiscal stimulus could add inflationary pressures and result in a stronger response from the Fed compared with market expectations. On the other hand, under-delivery of the stimulus compared with what is currently priced-in would push U.S. yields lower, thereby making emerging markets more attractive to investors.

Local Conditions Matter Too
Against this global backdrop, country-specific circumstances are important drivers of sentiment, with a country’s economic prospects, domestic political developments, and geopolitical uncertainties on investors’ radars. In turn, capital flows may influence short-term growth prospects via their impact on currencies, inflation, and bond yields.
Economic and financial conditions are therefore quite different in major emerging markets in Europe, the Middle East, and Africa (EMEA).
Russia’s economic prospects have improved, while external pressures have largely subsided. The economy has recovered from the two-year recession, and we expect GDP growth to average 1.5% this year, and 1.7% in 2018. The Russian ruble has been strengthening, gaining 13% since end-November (chart 3), and 19% over the past 12 months.
Exchange rate appreciation reflects a pick-up in oil prices, but also more favorable capital flow dynamics: Net capital outflows (both resident and nonresident) slowed to $15 billion in 2016, down from $57 billion in 2015. Annual inflation fell to 4.6% in February (chart 4), not that far away from the central bank target of 4%. A stronger exchange rate, muted demand pressures, and a tight monetary and fiscal stance have all supported disinflation. We expect the central bank to reduce the key rate to 8% by end-2017, from the current 10%. Meanwhile, long-term rates have been trending down, with 10-year sovereign bond yields falling to 8%, from 9.2% a year ago (chart 5).

While investors’ interest in Russia has risen, foreign flows are nevertheless constrained by international sanctions imposed in 2014 by the EU and the U.S. (and some other countries including Japan), which restrict the access of Russian borrowers to Western capital markets.
In Turkey, domestic political developments, geopolitical uncertainties and security issues, coupled with a volatile external backdrop, have taken a toll on the economy, which until recently had showed resilience to domestic and external shocks. GDP contracted in the third quarter of 2016, and growth slowed to 2% for 2016 as a whole, by our estimate, well below average growth of 5.6% over the previous two years. We lowered our growth forecast for Turkey in January, to 2.4% in 2017 and 2.7% in 2018, down from our previous expectations of 3.2% and 3.4%, respectively.
Nonresident portfolio flows into Turkey turned negative in November. While this was in line with global trends, Turkey did not enjoy a recovery in flows over December-January, unlike other emerging markets. As a result, the Turkish lira lost more than 20% of its value between end-October and end-January. The drop in the lira fueled inflation, which exceeded 10% year on year in February (chart 4). Bond yields rose to 11% in December from 9% mid-2016. The Central Bank of the Republic of Turkey (CBRT) has left the key rate unchanged since November, but has nevertheless tightened liquidity conditions. The average rate of central bank funding increased to 11.3% in March, from 8.3% in December. This helped stabilize the currency, but the situation remains volatile. It remains to be seen whether the CBRT’s response will be sufficient to stem further depreciation, especially since it is delivering its tightening via multiple interest rates, rather than in a more transparent way via a hike in the key rate.

The impact of tighter global financial conditions on South African financial markets has been muted so far. The rand lost about 6% of its value after the U.S. election, but has since recovered its losses and continued to strengthen. The rand exchange rate is now about 20% stronger than a year ago. However, this is mainly due to a recovery in prices of commodities exported by the country, as well as the impact of a big cross-border merger transaction resulting in significant equity inflow. Despite the stronger rand, inflation remains outside the 3%-6% target band, on the back of higher petrol prices and elevated food prices. Inflation has likely peaked, as the drought’s effect on food prices should gradually dissipate, while international oil prices have stabilized. The South African Reserve Bank has kept its policy rate unchanged at 7% since March 2016, confirming at its meeting in January that the central bank is near the end of the hiking cycle that started three years ago.
We think that the range of negative shocks that dragged down GDP growth in South Africa over the last couple of years, such as the fall in commodity prices and the severe drought, have run their course. Nevertheless, there are still many structural constraints on South African economic growth, in particular related to the poor functioning of the labor market. Moreover, we think that political infighting has distracted from much needed growth-enhancing reforms.
Therefore, our expectations are for subdued growth of 1.4% in 2017 and 1.8% in 2018. This means that in per capita terms, South Africa’s real GDP growth will move into positive territory only in 2018.

Tatiana Lysenko – Senior Economist – Standard & Poor’s