EM Storms Could Spread To Europe

http://www.ft.com/cms/s/0/03acf9f0-098b-11e3-8b32-00144feabdc0.html#ixzz2cXAczb6b By Ralph Atkins in London Periphery eurozone bond markets could be next in line for sell-off At the start of this year, emerging market turmoil was on few investors’ worry lists. Top preoccupations were US fiscal woes, the rumbling eurozone debt crisis and a possible “hard” landing for China’s economy. Nobody really considered what would happen if all those threats did not materialise. The financial storms hitting India and other developing economies this week are the answer. With the US economy having successfully avoided possible global upsets and growing steadily, the US Federal Reserve wants to wind down its asset purchases, or “quantitative easing”, from as early as next month. As a result bond prices have fallen, and yields risen correspondingly, in developed markets – and the strong flows of capital into emerging markets that had been attracted by higher yields there have gone firmly into reverse. Worst hit have been countries most reliant on capital inflows – those with gaping current account deficits to finance. In India, where the deficit exceeded 5 per cent of gross domestic product last year, the rupee has tumbled to a record low against the dollar. Equity prices have fallen precipitously, while 10-year bond yields have approached 10 per cent, the highest for five years. The good news is that this has not yet spun into a full-blown emerging market crisis, and the Fed can control the pace at which it “tapers” asset purchases. European shares are benefiting as an alternative contrarian trade for investors looking for underrated assets. The bad news is that we are still at the start of the process of exiting global QE and the effects will spread – including, perhaps, to weaker European economies. Much of what is happening in emerging markets is the result of national factors – India’s troubles have been exacerbated by seemingly cack-handed political decisions. It is also true that global investors fell out of love with emerging market equities long before Ben Bernanke, Fed chairman, first hinted at tapering on May 22. Thus the extent to which tapering is causing the emerging market tensions is disputed. But it seems obvious that tapering talk has at least exacerbated the sell-off. Outflows from Bric (Brazil, Russia, India and China) bond funds have been equivalent to almost a third of assets under management since May 22, according to EPFR, a funds data provider. That compares with just 4 per cent from the start of the year until Mr Bernanke spoke. Moreover, there has been a clear relationship between the size of current account deficits and the extent to which countries have been hit by the financial turmoil – strengthening the argument that it is reversed QE flows that are the main culprit. Indonesia, where the current account also deteriorated sharply last year, has seen some of the sharpest equity price falls. South Africa, Turkey and Brazil have, like India, seen steep rises in bond yields and tumbling dollar exchange rates. Ominously, the lesson of economic history is that when capital inflows go into reverse, the turnround is often abrupt and painful. Nor are surplus countries immune. When emerging market fund managers have to finance sudden large outflows they are forced to sell higher-quality, more liquid assets – and the effects spread. For Europeans, this week’s events are eerily reminiscent of the damage wreaked on the Baltic states that were running massive current account deficits when the global financial crisis erupted in 2007. Eurozone bond yields have remained steady for the (not entirely positive) reason that fickle foreign investors have already fled the region’s weakest markets. For a while, weaker members of the eurozone were protected by the currency union. But then the eurozone itself was almost torn apart as strong capital flows from the continent’s north to the southern periphery went into reverse. Fixed exchange rate regimes sometimes lull investors into a false sense of security by delaying an inevitable correction. This week’s emerging market turmoil will encourage the shift in investor sentiment back towards developed economies, especially those returning to internally driven, self-sustaining growth. The risk for Europe, however, is that periphery eurozone bond markets could be next in line for a sell-off. If German 10-year Bund yields are rising – they have this week exceeded 1.9 per cent, compared with less than 1.2 per cent in early May – yields below 4.5 per cent on Italian and Spanish equivalents look less compelling. For now, eurozone bond yields have remained steady for the (not entirely positive) reason that fickle foreign investors have already fled the region’s weakest markets. But we are at the start of a long process in which US monetary policy will evolve – with effects nobody can predict with confidence. Taylor Scott International

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