(Bloomberg) — The appreciation of the dollar over the past year means some emerging markets are increasingly facing capital outflows. The weakest are beginning to falter, sending a warning signal to the EM as a whole.
In a dollar-based system, countries have dollar liabilities but local currency assets. Eventually, when the US currency appreciates, it puts unbearable strains on national balance sheets, weighs on the local currency, fuels inflationary pressures and dampens domestic growth. Just when such countries need capital, higher US yields act as a magnet for international flows, sucking capital away from them.
EMs are the weakest hands. Not being able to lend in one’s own currency often leads to the “original sin” of borrowing in a hard currency, principally the dollar. Such overruns have been very popular in recent years, with the amount of cross-border dollar-denominated loans outstanding in emerging markets quadrupling since 2006 to more than $4 trillion.
Capital outflows from emerging markets have been relatively limited so far, but pressure is mounting as US yields are at over 10-year highs while the dollar is at its strongest in 20 years. This is tightening global liquidity, pointing to an accelerated outflow of capital from emerging markets.
Reserves are the first line of defense when a country’s cash flow situation becomes unstable. But not all EMs are equally at risk.
I have created an external vulnerability measure based on the IMF Reserve Adequacy Score. This version has three inputs: export adequacy of reserves, short-term debt (the latter being the Greenspan-Guidotti ratio), and the current account balance.
The measure identifies Turkey, Chile, Hungary and Argentina as the most vulnerable to capital outflows.
Still, Turkey and Chile have posted the best equity returns so far this year (even in USD terms).
This may seem paradoxical, but Chile and Turkey in particular have one of the highest and fastest rising inflation rates. Equities are generally viewed as an inflation hedge (a wrong assumption, certainly in DM markets) – leading to supportive flows.
This was certainly the case in Turkey, where President Erdogan has favored rate cuts in response to inflation now over 80%. With bond yields hovering around the 10% mark, the 100% to 150% yields on offer in the stock market are almost irresistible.
Both stock markets are now facing increasing headwinds. There are country-specific reasons that could explain this – a collapse in Turkish bank stocks, political and social unrest in Chile.
But both countries are facing an increasingly intolerable reversal in capital flows, exacerbated by rising energy prices and, in Chile’s case, falling copper prices.
As two of the very few EM or DM stock markets with a positive YTD return, their recent troubles are a harbinger for other EMs, mainly those heavily dependent on foreign funding and a stronger dollar.
- NOTE: Simon White is Macro Strategist for Bloomberg’s Markets Live blog. The observations he makes are his own and are not intended as investment advice. For more market commentary, visit the MLIV blog
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