How Resilient Is EM To The End Of QE – A Vulnerability Heatmap
The adjustments in core rates markets driven by repeated Fed commentary about its QE policy led to widespread selloffs in EM assets - and as we explained yesterday, this has potential vicious circle implications for developed markets. The significance of the EM selloffs has raised concerns about whether investors could abandon the asset class and trigger 'sudden stop' scenarios as they prepare for a post-QE world. Barclays believes we have likely entered a 'bumpy transition' towards a normalization of core market interest rates, and while they agree with us that the fundamental vulnerability to an end of QE may still reside with many DMs (eg, euro area periphery), rather than EMs, the large capital inflows into EM economies makes them extremely vulnerable to a rapid outflow of external capital.
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It should be noted at the outset that QE was a policy reaction to pressures at the core of the global financial system and the very high DM debt levels that threatened to push major advanced economies into a recession-deflation cycle. Although deflation threats may have abated, public debt levels in DMs have adjusted little. Hence, the fundamental vulnerability to an end of QE may still reside with many DMs (eg, euro area periphery), rather than EMs.
However, QE pushed large capital flows into EM economies. These flows imply cheaper external funding, push domestic interest rates lower and thus can lead to rapid domestic credit growth, rising domestic consumption and investment, widening current account deficits and higher inflation (ie, loss of external competitiveness). Leverage on private and/or public sector balance sheets increases. A sudden stop withdraws access to external financing, creates FX funding pressures and pressures FX. Depreciation then exposes FX balance sheet mismatches, potentially turning FX liquidity problems into solvency risk.
Our heatmap includes many of the well-established external vulnerability indicators. To account for the particular QE context, we:
- Put emphasis on the flow aspects related to QE – that is, not only current debt stocks or leverage ratios, but also the speed with which these stocks (eg, domestic credit, external and government debt) and ratios (loan-to-deposit ratios) have changed;
- Added a focus on portfolio flows and foreign portfolio positioning in local markets, which has been a particular QE-related phenomenon;
- Include variables that indicate how much the domestic policy response has exposed the economy (real policy rates; FX coverage of foreign portfolio positions);
- Used trends in recent ratings and the current rating outlook as indicators of how fundamental trends are being perceived more generally.
EEMEA still stands out with the most pressure points: large external borrowing needs, high loan-to-deposit ratios and low real rates. The largest (SA, Turkey) and smallest economies (Ukraine, Serbia) look vulnerable to a sudden stop. In contrast, Russia seems less exposed. In EM Asia (ex-China), the vulnerabilities are lower and concentrated in the banking system, where leverage has risen. Indonesia stands out in this regard. In LatAm, Brazil shares this characteristic of rapid banking sector external borrowing. Argentina and Venezuela have the most pressure points. Mexico looks exposed to portfolio outflows given high foreign positioning and limited reserve coverage, but it is sound on many other indicators. From a product standpoint, some indicators are more important than others.
Local rates and FX: Critical for us are countries where large external financing needs are mainly met by foreign portfolio flows. South Africa (where a primary fiscal deficit exacerbates the risk), Turkey and India (to a lesser degree) stand out in these categories. Low or negative real interest rates are a warning sign of the impact of past large inflows, which could reverse. The FX coverage ratio of foreign holdings of local bonds is also key if positions are unwound. The majority of EM reserves cover more than 100% of these positions with Mexico (105%), SA (130%) and Turkey (154%) at the lower end of the scale.
Credit: In credit, investors are likely focused on public debt dynamics and governments’ reliance on international liquidity to fill fiscal gaps. In this regard, the adverse public debt dynamics in countries such as Serbia, Ghana and, to a lesser extent, Ukraine over the past couple of years, coupled with still relatively high fiscal deficits, raises concerns. This is particularly the case if lower ratings suggest more limited debt-servicing capacity than in advanced EM countries and if the share of FX debt in the overall borrowing mix is high.