Jan Dehn, head of Research at Ashmore, discusses why events in Ukraine are a reminder of how damaging the Cold War was for Emerging Markets and why the ‘Fragile Five' are gradually turning into the ‘Frugal Five'.
Jan Dehn, head of Research at Ashmore, discusses why events in Ukraine are a reminder of how damaging the Cold War was for Emerging Markets and why the ‘Fragile Five’ are gradually turning into the ‘Frugal Five’.
Ukraine is an unpleasant reminder of the Cold War
Ukraine’s problems are a potent reminder how damaging the Cold War era was for EM countries. During that time, the internal affairs of many EM countries regularly fell hostage to tensions between Superpowers. Superpowers variously sponsored and unseated local despots that were allowed to rule with impunity at the expense of local political accountability.
Fortunately, today only a very small number of EM countries are caught up in Cold War dynamics today. Ukraine is one. Syria another. Egypt a third. This small group of unfortunate countries are riskier than other EM countries, especially if they also have sharp internal divisions that can be exploited.
Still, we think Ukraine is likely to end up in a different place than Syria. Ukraine already has a new government and much now depends on the strength of its leadership. Its primary task has to establish economic stability, which in turn will generate greater legitimacy. Strong leadership will also force EU/US and Russia to work to Ukraine’s priorities, not the other way around. But clearly final clarity about the longer-term political outlook will only arrive after the elections scheduled for May this year.
The IMF now needs to respond quickly to Ukraine’s economic stabilisation program with an offer of a full financing package, including measures to stop the on-going run on the banks. Russia’s voting share on the IMF board is less than 3%, well below the 15% required for a veto, so politics should not interfere too much on that front.
Ukraine’s debt levels are relatively low and the country is solvent, though secession by Crimea would worsen the debt dynamics in the rest of Ukraine. Still, for now, Ukraine’s economic problem is essentially a liquidity problem. International insistence on a haircut on privately held debt, such as in Greece, or, say, confiscation of foreign private bank deposits, such as in Cyprus, would therefore be major policy mistakes.
They would discourage rather than encourage new private money and hurt business confidence. This would snuff out the rapid recovery, which remains eminently possible in Ukraine due to the country’s low sensitivity to higher interest rates (small construction sector, etc).
By contrast, a deepening of the economic crisis would quickly backfire on the interim administration and thus threaten the shift of political accountability away from Russia (under Yanukovich) towards the people. We expect the IMF to assess the interim administration’s adjustment proposal. We expect the leading candidates for the election in May to stay relatively quiet during the adjustment phase to avoid being tainted by the bitter medicine.
The Frugal Five
Last year, ‘Fragile Five’ became a catchy phrase to denote countries with current account deficits perceived to be in danger of crisis due to Fed tapering. Today, it may soon be more appropriate to label these countries the ‘Frugal Five’.
All five countries have raised interest rates, all have adjusted their currencies, some have undertaken major fiscal adjustment too. These include changes to subsidy policies and, in the case of Brazil and Turkey, reversals of some of the more heterodox policies.
It is clear that these countries never faced serious crisis risk. Instead, they faced the type of standard macroeconomic adjustment challenges that all countries face in the course of regular business cycles, usually self-inflicted rather than caused by anything the Fed has done. Stocks of reserves were simply too large, debts too low, and the room for policy adjustment too large to trigger crises, despite the very negative external environment.
Let us remind ourselves of the latest developments in the ‘Frugal Five’:
• India‘s trade deficit has halved, real growth has begun to rise after bottoming out at a still impressive 4.5% yoy rate in Q2 2013, and inflation has fallen sharply from more than 11% in late 2013 to 8.8% today.
• Brazil‘s growth rate more than doubled in 2013 compared to 2012, despite sharply rising policy interest rates and spending cuts that also helped to push down inflation. Indeed, last week the government released GDP growth for Q4, which showed that 2013 growth was 2.3% (from 1.0% in 2012) due to a much stronger than expected Q4 print (+0.7% qoq versus +0.3% qoq expected).
• South Africa‘s real exchange rate – a competitiveness indicator – has improved by more than 15% over the past 12 months against a backdrop of better than expected fiscal performance. Last week the government published a tighter than expected budget against a backdrop of realistic expectations of rising growth and declining inflation.
• Indonesia‘s trade balance has moved into outright surplus on a 3-month rolling average basis, while 2013 real GDP growth surprised to the upside at 5.8%. Inflation has also stabilised and should decline significantly over the coming months as the effect of recent subsidy reductions pass through the data.
• Turkey reacted much later than the other four and the full improvement in external balances and inflation rates still lies ahead of us. Still, the trade deficit dropped from USD 9.9bn in December to USD 6.8bn in January. We expect the recent decision by the central bank to raise rates to depress imports, while a more competitive currency will benefit exporters. The combination should produce significantly stronger external accounts this year as the inflation pass-through from the exchange rates begins to fade.
The turnaround in the ‘Frugal Five’ illustrates two important points about EM economies. Firstly, EM policy makers may occasionally be late in adjusting (usually for fear of causing instability), but when they move they tend to do so decisively, with political backing. Secondly, EM countries have sound deeper fundamentals, so once their policy adjustments have begun their economies tend to respond quickly. It also helps that they tend to have highly flexible markets.
That is not to say everything is rosy in the ‘Frugal Five’. It never will be, by the way. The legacy of having dabbled in discredited heterodox macroeconomic policies will make it difficult for Turkey and Brazil to generate a strong private sector investment response in this recovery.
Turkey is also in the midst of an explosion of domestic political scandals (but we think the economic risks are much smaller). All five countries go to elections this year, so some short-term reticence among investors can be expected both at home and abroad. In Indonesia, India, and Turkey the elections have the potential to bring genuine renewal, but in Brazil and South Africa we do not expect major changes in the government.
Countries do not have to be perfect to warrant investment: they just have to be better than what is priced in and what is available elsewhere. The sooner investors get their heads around the fact that as a whole the 65-strong EM countries are generally healthy – including the ‘Frugal Five’ – the sooner they will see that EM is precisely that, better than what is priced in and better than what is available elsewhere.