The Indian rupee plummeted to a record low of Rs 58.98/$ on June 11, deepening worries about the country’s current account deficit and complicating the task of the RBI as it tries to loosen monetary conditions in a bid to spur economic recovery.
The latest slide is also significant as it has come in the backdrop of RBI foreign currency reserves depleting by $3 billion during the last week of May alone.
Foreign investors have been heavy sellers in recent weeks of Indian debt (over $7.5 billion with another $2 billion in the waiting), a key risk for a country that has come to depend on capital inflows to finance its current account deficit and support its markets.
Sell in May and go away? This old adage certainly came to the forefront in emerging markets. The only difference — selling is likely to continue in June, July and August if investment returns in the once-hot sector keep getting slammed by moves in US bond yields and the dollar.
The genesis of the recent fall in emerging markets may be traced to yields on 10-year benchmark US Treasuries rising above 2 per cent on May 22, after the Federal Reserve’s latest policy minutes sparking fears the central bank could start tapering off its bond purchasing programme as soon as this month.
Shortly afterwards, EM currencies began to tumble. Since then, the South African rand and the Brazilian real have touched four-year lows against the US dollar, and the Indian rupee has fallen to a record low. Even relatively robust countries such as the Philippines and Mexico — long favourites of investors — have been hit by a spate of selling. Some central banks have begun to intervene to stem the currency slides.
Emerging markets have also been hit by weakness in commodity prices and local political issues. Turkey, for example, has been rocked by protests that have sent the nation’s markets into a tailspin.
The Fed’s balance sheet has expanded by $2.29 trillion since Quantitative Easing (QE) began in August 2008 (see graph). In the same period, forex reserves at the Asia-10 expanded by $2.17 trillion (see Table).
The growing forex reserves act like an increase in the money supply that fuels deposits and loans. If the Fed scales back, the process “should inevitably go into reverse.” It could be akin to “a margin call on Asia.”
One would expect the Fed to keep its exit as orderly as possible. My concern is that, as expectations start to build, no one will want to be the last to exit. This could prompt markets to scramble to cover dollar-short and build dollar-long positions, exacerbated by multiplier effects, which could still lead to disorderly consequences.
Table 2 shows the risk is greatest in China, where forex reserves have soared by $1.56 trillion.
US gain, our pain
The weakness that you see in EM [emerging markets] is a trend weakness because emerging markets have lost their growth model. Exports aren’t doing very well, current accounts surpluses are coming under strain, deficits are rising.
Memories of 1994 have been stirred by recent talk that signs of a US economic recovery could induce the Federal Reserve to scale back its money-printing, risking a repeat of the EM (emerging market) bloodbath that followed Alan Greenspan’s decision to start tightening policy almost 20 years ago.
As years of rock-bottom US yields draw to a close, emerging markets may be victims of the Fed’s success in pulling the US economy out of its stalemate.
During these years they have enjoyed an investment bonanza. Over $46 billion has flowed to emerging stock and bond funds since January, after almost $90 billion last year.
But 10-year US Treasury yields, considered the risk-free benchmark for most assets, rose 40 bps in May while the greenback surged. And while some weak US economic data has dampened expectations the Fed will end, or taper, money-printing early, the emerging markets sell-off shows no sign of abating.
The big picture is: the US economy is recovering and the Fed has signalled that tapering will happen.
Put simply, an investor comparing 10-year US yields at 2.2 per cent with the 5.2 per cent offered by, say, Chile, might well, given the skew of currency risk, opt for the former.
That is partly because real interest rates — taking into account inflation — in most emerging markets are negative and have fallen below US real rates. This round of US recovery, possibly fuelled by re-industrialisation rather than relying on emerging market imports, may not be bullish for the developing world.
The boom in recent years has meanwhile slashed yields on emerging debt. JPMorgan’s GBI-EM index yielded a record low 5.2 per cent in early May, 120 bps less than a year earlier.
What FIIs Sold in May
The panic over US rates blew emerging dollar bond spreads almost 20 bps wider over Treasuries in May to bring 2013 returns to (-) 3 per cent. Local debt yields meanwhile rose 50 bps, with returns tipping into the red in the past week.
Emerging equities slumped more than 3 per cent, their biggest monthly loss in a year, while currencies, which typically make up a significant portion of investors’ annual return, have also slipped.
According to UBS, an equally weighted basket of 20 emerging market currencies that it tracks has lost 3.7 per cent to the dollar this year.
Foreign investors are estimated to hold a third of emerging local debt and more in countries such as Peru and Hungary.
The money flowing out of China funds was the largest amount since February 2011. The Shanghai Composite, Asia’s laggard index, has struggled to gain traction in recent months, weighed down by the uncertain growth outlook for the world’s second largest economy. It is down 2.6 per cent year to date.
However, fellow BRIC markets have fared much worse than China. Brazil’s benchmark Bovespa Index has lost 13 per cent since the start of the year, while Russia’s RTS Index is down 15 per cent over the same period.
The MSCI Emerging Markets Index is down 7 per cent year to date, far underperforming the MSCI All Country World Index which is up almost 7 per cent.
The Fed’s bond buying programme has led to ample liquidity in emerging markets in search of higher returns, but a paring back of stimulus is expected to heavily dampen appetite for risky assets.
While all currencies are depreciating against the dollar, the ones that have declined the most are from countries with large current account deficits, viz. South Africa, Turkey and India. South Africa’s rand is at four-year lows while bond yields have jumped a whole percentage point in May.
REFORM IN INDIA
India is, unfortunately, a leader in this category. Despite all the public hand-wringing about the size of the current account deficit, very little has actually been done to rein it in. While domestic fuel prices are gradually being corrected, consumers are yet to pay the full rupee price of diesel and liquefied petroleum gas for domestic use.
Measures to dampen demand for gold are widely perceived to be misdirected and unlikely to have material impact.
On the mineral front, little has been done to revive the once substantial iron ore exports, while the country’s power sector remains dependent on imported coal.
The Food Security Bill sought to be introduced by the UPA government will only add to the already bourgeoning deficit.
Indian government needs to simplify tax, reducing the necessity to file so many tax returns, even if electronically. A single window clearance for all Greenfield projects is the need of the hour. All this does not require the approval of the Opposition.
Auctioning is still the best way to allocate scarce natural resources. A strict hand is required to deal with all corruption cases. I am surprised IPL6 was even allowed to conclude.
Due diligence needs to be exercised while and after appointing people to positions of power as there is rampant misuse of power for personal gain.
The EM sell-off has been much more fixed income-focused than equity-focused...correlations between EM bonds and foreign exchange have shifted to high levels; a sign of indiscriminate position liquidation.
I believe the fall in emerging markets as an asset class is expected to accelerate over the next few months. Rupee could cross the psychologically important level of Rs 60/$ shortly and bring with it further pressure on the Indian stock indices and severely curtail the ability of the RBI to cut interest rates, thus resulting in a vicious circle of low growth and negative real interest rates.
(The author is CEO, Global Money Investor)