Most EBRD countries relatively unaffected despite renewed pressure on emerging markets
As of 31 January 2014
- Global emerging markets (EMs) have come under renewed pressure since late January, but many countries in the EBRD region have been comparatively unaffected by market concerns over tapering. Stock markets and exchange rates have seen a trend strengthening since May 2013, and notwithstanding some declines in equities in the past weeks – in line with global trends – most transition countries have remained relatively resilient.
- The main reasons are improved fundamentals; relatively little reliance on volatile portfolio flows and, more recently, positive developments in the eurozone to which many of the EBRD EMs are closely linked.
- Notable exceptions include Turkey and Ukraine, where vulnerability to external financial conditions have been joined by domestic turmoil in recent months. Russia has also experienced a depreciation of 5% since the start of the year.
- Markets are likely to remain volatile as the Fed gradually reduces the scale of its asset purchases and as the “commodity super-cycle” is ending with the slowdown of emerging market demand. Cross-border bank deleveraging will likely continue, putting additional, though generally not major, pressure on EM funding in the EBRD region.
- In this environment the strength of domestic fundamentals is likely to prove a critical determinant of EMs' resilience and the extent to which they suffer capital outflows.
Capital outflows from emerging markets are continuing amid a gradual tightening of monetary conditions in advanced economies. Pressure on EM currencies has continued following the Fed’s decision on January 29 to taper its quantitative easing program by an additional US$ 10 billion. The global reallocation of capital has led to increased differentiation among emerging markets, based on economic fundamentals and policies.
Developments in the EBRD region
Most countries in the EBRD region have remained resilient amid volatility in global emerging markets. The reasons for this comparative stability are discussed in an earlier blog post: “Is emerging Europe a new safe haven? ”. Chart 1 shows that while currencies and equities have weakened in many of the main emerging economies, the reverse is true for much of the EBRD region. Countries in the CEB and SEE regions, in particular, have largely seen appreciations against the US dollar since May 2013.
The comparative stability of currencies does not reflect a depletion of reserves. In principle EBRD countries could have offset exchange rate pressures by using FX-reserves. However, notwithstanding occasional interventions, the majority of countries international reserves saw increases in reserves in the second half of 2013 (see Chart 2). Significant exceptions are Belarus, Ukraine, Kazakhstan and Mongolia, all of which lost reserves and suffered depreciations despite currency interventions.
EBRD countries that are dependent on market access to finance their current account deficits and meet external debt obligations will be more vulnerable to QE tapering and the associated volatility. In quite a few countries the current stock of reserves would be inadequate to meet gross external financing requirements (Chart 3). In the case of Belarus and Ukraine external funding needs are more than twice the amount of total reserves. This is true of the latter even when accounting for $20 billion of promised Russian assistance.
The effect of current market volatility on EBRD countries also depends on the composition of earlier capital inflows. Following the 2008/09 crisis, capital flows to the region have been both moderate and primarily composed of FDI. Turkey constitutes an exception, relying on significant portfolio inflows in recent years to finance its current account deficit. These flows are more volatile than FDI and more responsive to short term changes in global financial conditions.
Notwithstanding the comparative resilience to market volatility, the EBRD region has experienced capital outflows. As reported in EBRD’s latest forecast (REP, January 21), total private flows to the region turned negative in Q3 2013 for the first time in two years. Non-FDI (portfolio) capital outflows from the CEB and SEE regions turned negative and FDI inflows were not sufficient to compensate, as they did jointly in the past, for ongoing cross-border bank deleveraging. Higher frequency data on fund flows indicates that outflows continued through December 2013 (Chart 4).
In the EBRD region, Turkey and Ukraine are among the countries most vulnerable to global volatility. They, along with Russia, suffered depreciations in recent weeks.
In Turkey, the central bank effectively hiked interest rate by 225 basis points and reverted to a more conventional monetary framework in an emergency meeting held on Tuesday night.
The pressure on the currency has reappeared since mid-December, with the lira reaching a trough early this week, losing 15% against the dollar, and around 25% over the past year. This rendered the lira one of the most affected currencies in the world, and is a likely source of further inflation pressures in a setting in which inflation has already been overshooting the target for the past two years. The currency pressure came amidst recent elevated political uncertainty, coupled with the Fed’s decision to begin tapering its quantitative easing programme. It may also have been affected by the market perception of weakened credibility of the central bank.
Tuesday night’s rate hike is widely seen as a necessary step to restore confidence in the central bank and anchor inflation expectations. Markets initially reacted positively, with the lira appreciating by 4 per cent, but early gains were subsequently eroded in line with ongoing EM currency weakness. While the market has broadly stabilised since the announcement of the latest hike, pressure on the exchange rate may still reappear when the Fed tightens further and if markets remain unconvinced about the effectiveness of central bank tightening in the context of domestic political uncertainties.
Affected by deep domestic political crisis, Ukraine’s hryvnia depreciated by 4 per cent since late-December to the lowest level since September 2009 notwithstanding tight capital controls, and CDS spreads widened sharply to over 900 basis points. The political crisis is affecting Ukraine’s macro-financial stability though pressures on the currency and raising the risk of domestic capital flight. The National Bank of Ukraine reportedly intervened in the interbank market to stem the decline of the currency. Eurobonds were selling-off over concerns that the Russian deal may be delayed or suspended after the resignation of the PM and likely reshuffle of the government.
Given these circumstances, S&P’S lowered its long- and short-term foreign currency sovereign credit ratings on Ukraine to closer to default rate at CCC+/C from B-/B on January 28. Currency and bond markets have stabilised temporarily after political talks produced some results, and the degree of stress has subsided for now. It would hence appear that the main source of market distress is domestic rather than external.
The rouble depreciated by 5 per cent last month against the basket of US dollar and euro, of which 1.5 percent corresponds to the past week. In addition to generalised emerging market turbulence, this could reflect a weakening current account position (a surplus of only 0.4 per cent of GDP in the last three quarters) with capital outflows rising again (3 per cent of GDP last year), the downward direction of oil prices (5 per cent down year-on-year in January; 1.2 per cent down month-on-month), and a policy response conducive to speculative bets against the rouble in the short term.
Looking ahead, markets may take comfort from several facts: (i) the Central Bank of Russia remains committed to greater exchange rate flexibility (as part of a broader policy of moving towards inflation targeting); (ii) international reserves stand at almost US$ 500 billion (24 per cent of GDP), though around US$ 14 billion was used to smoothen currency movements between mid-December and mid-January; (iii) the Central Bank has increased provision of liquidity to the banking system, and a further weakening of the rouble would be unlikely to prompt heavy intervention.