What are "The Fragile Five" Emerging Market Countries…and Just How Fragile are They?
There are 45 countries classified as emerging market economies. They exhibit varying levels of economic growth, inflation, trade and fiscal conditions. Their differences have been on full display since last May when the Fed first began discussing plans to taper its monthly asset purchase program (QE3). The prospect of higher yields in rich countries made investors reluctant to pour more into emerging economies. Although the subsequent sell-off in emerging market assets/currencies was broad-based, five countries — Brazil, Turkey, Indonesia, India and South Africa, known collectively as "The Fragile Five" — showed particular vulnerability.
The sudden stop and reversal of capital flows into the Fragile Five had been blamed to some extent on high inflation, slowing economic growth, and in some cases exposure to China's slowdown. Investors, however, were particularly turned off by the large current account deficits, the broadest measure of the trade gap, which puts these countries into a position of being too dependent on short-term foreign investment flows (typically nervous) to finance their growth.
Economic growth in all five countries slowed somewhat in 2013 in large part due to structural/internal problems. Indeed, Indonesia's slowdown had been gradual, but India, Brazil, Turkey and South Africa all grew at rates at least two percentage points slower than they were in the pre-crisis period.
To add to the uncertainty, each of the Fragile Five is due to hold important elections in 2014; and those elections will no doubt delay structural reforms and add to market uncertainty. Having said that, while the elections provide an opportunity for a fresh start, only in Indonesia does it look like elections will make a notable difference to the policymaking environment.
Here's a quick rundown on the Fragile Five and what to watch for:
1. Brazilian real (BRL)
- The real fell in 2013 by 22% vs. the USD in the period following the Fed meeting in May (see 2013 full year stats in chart below), and is up nearly 1% YTD 2014.
- Brazil is running a high current account deficit of 3.7% of GDP and has an inflation problem – last year we saw locals protesting the high costs ahead of the World Cup. Fortunately, it has a healthy stockpile of foreign exchange reserves to call upon if necessary. And, according to The Economist, "although the credibility of the Brazilian government has been eroded, the central bank has clawed back some respect by pushing through interest rate hikes."
- In January 2014 the Brazilian government's budget deficit as a percentage of GDP rose to 3.6%, the widest deficit in four years. The chief economist at Banco Espirito said "the first sign this year of how the government is doing on fiscal policy was a disaster." Not good.
- Brazil will see presidential, general and local elections in Q4 2014.
2. Indian rupee (INR)
- The rupee fell by 15% in 2013 following the Fed meeting in May, and is basically flat YTD 2014.
- India's consumer price inflation is very high at 10.1%. Societe General wrote last week, "with export demand continuing to weaken and domestic consumption remaining highly fragile, the economy is clearly on weak footing."
- India will see general elections in May. The general feeling is that whichever party is voted in, it will need to form a coalition, which will lead stall any economic reforms.
3. Indonesian rupiah (IDR)
- The rupiah was the worst performing emerging market currency May to year-end 2013, down 26% versus the US dollar. It's up 5% YTD 2014.
- Indonesia's foreign reserves climbed above $100 billion in January for the first time since May. That's very good news.
- The rupiah appreciated by 5.2% in February as a narrowing in their current account deficit prompted foreign investors to increase purchases of the nation's assets. The C/A gap had shrunk to 1.98% of GDP in Q4 from 3.9% in the prior period.
- Some analysts expect a stronger rupiah after the presidential elections on July 9th. I tend to agree.
4. Turkish lira (TRY)
- The lira fell by 21% May to year-end 2013; and is down 3.1% YTD 2014.
- Turkey, considered the most fragile of the Fragile Five, surprised the markets on January 28th by raising their benchmark interest rate 4.25% percent to 12% to defend the lira. The New York Times reported that "the sharper-than-expected increase by the country's central bank — which previously took a fairly passive approach to defending its currency — was intended to persuade foreign investors, as well as corporate and household savers, to hold on to their lira instead of exchanging them for dollars."
- Turkey has sufficient FX reserves to cover short-term external debt for just one year.
- On the bright side, Turkey's economic growth comes mainly from construction, not from exports, and they have a large domestic consumption base.
- Turkey faces all the same problems as the other fragile five countries, but has the added geopolitical risk we read in the paper nearly every day now. Turkey sees municipal elections in March and a presidential election in August.
5. South African rand (ZAR)
- The rand fell by 18% May to year-end 2013; and is down 2.8% YTD 2014.
- South Africa's twin deficits are very high, and the country is vulnerable to a slowdown in China and the impact it would have on commodity prices, specifically industrial metals.
- South Africa only has FX reserves to cover their short-term external debt for about one year.
- General elections will be held on a date in April-July, and should be a non-event for the markets.
The top graph shows the percentage change vs. the USD for 24 EM currencies for the year 2013. Our Fragile Five currencies line up perfectly as the worst performing EM currencies (save the Argentine peso, a story for another day). The bottom graph shows a nice reversal of fortunes YTD 2014 for the Indonesia rupiah, the Brazilian real, and to some extent, the Indian rupee. The EM currency sell-off in 2013 was clearly overdone, and after new Fed Chair Janet Yellen effectively soothed market tensions about tapering Q3, short (and hedged) EM currency positions were probably unwound a bit.
As confidence wanes, global investors have been withdrawing money from emerging markets and shifting into Europe at an increasingly aggressive pace. They are citing concerns that growth is faltering in emerging countries while strengthening in developed economies. The violent protests in Ukraine have certainly fueled geopolitical tensions across the entire EM asset class, and of course the slowdown in China sending ripples across the emerging markets as well.
Whatever the case, one should expect local factors — domestic financial regulation, macroeconomic policy, and political instability — to be dominated by global factors for at least another six months.
Be cautious. Even though the Fed is expected to do a good job of using forward guidance to calm global financial markets with regard to U.S. interest rates, I expect our Fragile Five currencies to be jumpy and uneasy over the foreseeable future. In that light, we think both strategic and tactical currency hedging make good business sense. Feel free to call me to discuss further.
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