Seasoned emerging market investors are often offered the opportunity to watch the same movie play out in different markets at different times.
We have been concerned about the ability of certain countries to continue funding their deficits through foreign portfolio flows for a number of years.
Previous emerging market crises in Thailand and Russia manifested against a similar backdrop. This time around we have been avoiding South Africa, Turkey, India and Indonesia – despite the enthusiasm generated by their growth stories.
Developed market investors, faced with negligible interest rates at home, had been pouring money into higher-yielding emerging market local currency bonds. This artificially supported the currencies and created an illusion of sustainable fixed income returns and attracted more money. This virtuous – but unsustainable – circle led to the currencies becoming increasingly overvalued.
Exit blocks
Countries with large current account deficits were able to obtain the dollars they needed thanks to this mechanism – until this year. Finally, fixed income investors realised they were being offered below-inflation returns to own risky foreign currency emerging market government bonds.
The problem was, they had ended up owning very large portions of the domestic markets and the exit route was too small – leading to a sharp correction in many currencies and stock markets.
We feel it is too early to be getting excited about most of the emerging markets with large external financing requirements.
Turkey needs dollars to plug a current account deficit exceeding 7% of GDP, while in South Africa the figure is over 6%.
Foreigners still own almost 30% of both these bond markets – double the levels of 2010. Indonesia has a smaller current account problem, but over 30% of its domestic debt is held by foreigners and currency controls have made it extremely difficult to exit.
Potential in India
The one market we have become more positive on is India. The 25% correction in the rupee by August this year has created opportunities – especially since India boasts a number of companies with foreign earnings. The appointment of a new reputable central bank head may have proved a turning point for the currency and the market.
Although India’s current account deficit exceeds 4% of GDP, there are some mitigating factors.
Foreigners are barely present in the domestic debt market and net external debt is below 10% of GDP. This means India is far less dependent on fickle fixed income investors.
Energy reforms
India’s deficits are mainly driven by energy. Last year, imports of oil amounted to almost 10% of GDP.
The government subsidises around 60% of domestic oil products – this consumes up to 20% of the budget.
This policy has the twin effect of increasing the budget deficit and artificially supporting consumption, increasing the current account deficit even further. There is now a realisation this is not sustainable and the government is slowly moving to address the problem.
Upcoming national elections could further accelerate the process.
Oil prices have reversed much of this year’s rally, easing the pressure on India’s deficit. In the medium term, the shale boom in the US should make available cheaper energy. In particular, this could improve the supply of LPG, widely used in India for cooking and currently heavily subsidised.
We have recently met a Greece-based shipping company that is already positioning itself to supply India with this additional source.
We have bought some of the large Indian oil companies that currently suffer from the subsidy regime, as well as exporters that benefit from a more realistic currency valuation.
Most emerging market crises have presented buying opportunities in the past. And although some of the region’s markets are likely to face further pressures, others, like India, may already be turning the corner.
Written by Matt Linsey, manager of the GAM Star North of South EM Equity Fund.
