This year has been a very unpleasant one for emerging markets (EMs). Investors have been abandoning them left, right, and centre, EM stock prices have slumped, EM currencies have weakened, and their prospects from here on out are looking pretty gloomy.
Indeed, according to a note from Societe Generale, 2014 is likely to be a very bad year for EMs: “Following the Fed's decision in September to postpone tapering, emerging markets (EM) rebounded strongly. But this relief rally has now stalled, as investors are cautious about the central bank's next move. Indeed the latest FOMC meeting confirmed the Fed's bias for tapering and the very good employment report released last Friday reinforces our economists' expectation of a March 2014 taper. The threat of rising global yields is a key downside risk for EM assets near term. Higher bond yields should trigger portfolio rebalancing and the “repricing of risk could spark a run by investors holding speculative positions”, says the IMF. The shock will be further amplified in countries with external imbalances and vulnerable financial systems.”
Basically, what SocGen is saying is that when the US Federal Reserve starts to reduce the size of its quantitative easing bond-buying programme EMs are likely to feel the pain. The Fed’s enthusiastic bond-buying has been shoring up markets around the world by flooding them with liquidity. Emerging market stock exchanges, which are generally considered riskier than their peers in developed countries, have been a major beneficiary of the Fed boost. And that means that EMs stand to get burned when the spigots close.
We’ve already seen evidence of this. Earlier this year, when it seemed likely that the Fed was going to start “tapering”, or reducing its rate of bond-buying, EMs around the world saw their stock markets and currencies plummet. What SocGen is saying is that as the Fed starts to taper, perhaps as early as March next year, we can expect to see the same thing happen.
SocGen also points out that certain countries are particularly vulnerable, especially those with external imbalances, or more specifically, countries with a lot of debt and significant trade imbalances. South Africa qualifies as one of these.
The country’s trade balance has been worse than expected every month for the last few months; South Africa has been importing much more than it exports, despite the weakening rand (see more here). And, thanks to counter-cyclical government spending and lower-than-expected tax takings, South Africa’s public debt burden has also been growing since the recession of 2009.
With a combination of a weak trading position and rising levels of government debt (although debt does remain within tolerable limits), South Africa is in a particularly vulnerable position as the Fed’s tapering programme draws nearer.
Another risk factor for EMs in general is a vulnerable financial sector. As SocGen explains: “In the past four years, credit growth has been excessive in many EM. The fast rise in household debt in some countries like Thailand and Malaysia is a growing cause for concern. A prolonged economic slowdown could trigger a surge in NPLs in EMs where debt levels have run up significantly and asset bubbles have formed. The banks which are the most exposed to these distressed loans could threaten the stability of EM financial systems and their economies.”
Although South Africa’s banking system is generally stable and well-financed – it shook off the financial crisis without much trouble – there has been a pretty sharp rise in credit extension to individuals, especially unsecured lending, and this could well expose the country’s financial system to a certain level of risk.
So what does this mean for the country heading into 2014? In the worst case scenario, it means that South Africa could face some serious headwinds next year when the Fed starts to taper. The rand could come under even more pressure, and liquidity could be scarce, leading to stock market weakness. The country could even see some pressure on its banking system if liquidity becomes scarce and the economy slows, causing a rise in non-performing loans.
Hopefully, given that there is time to prepare for tapering, this worst case scenario won’t come to pass. However, there is little that South Africa can do to protect itself, since the threat of Fed tapering is external and not within South African control. 2014 could be a bumpy year.