Wed | Jan 23, 2019

Sneak preview of 'emerging' slide

Published:Friday | November 21, 2014 | 12:00 AM
People walk past a display with exchange rates in downtown Moscow, Russia, on November 14. - AP
Walter Molano


Trailers can make or break a movie. Although they usually last a few minutes, a preview should catch the imagination and give a good indication of what lies ahead. One of the telltales that may portend the future of the emerging world, particularly Latin America, is the meltdown of the Russian ruble.

The currency lost more than 40 per cent since the start of the year, and the central bank's decision to float means that it could go lower.

While some Russian corporates are stressed, analysts and commentators do not seem too worried about the implications for the rest of the asset classes.

The Russian economy is pretty sound. The central bank has more than US$400 billion in reserves. Debt to GDP is under 15 per cent. The level of economic activity is flat, and the fiscal accounts are in the black. Moreover, debt amortisations are relatively light.

Capital Account Very Important

So, many people ask why the currency is even devaluing? The answer lies in the capital account. Most people look to the current account for clues to what will happen to the currency, but the capital account is just as important. Unfortunately, capital is streaming out of Russia. Capital flight was already high before the crisis, but the Ukraine conflict has exacerbated the problem.

Many asset managers culled their Russian exposure in response to the sanctions. There were fears that regulators would force them to cut positions, which would lead to a plunge in valuations.

To make matters worse, the precipitous decline in oil prices fanned expectations that the current account would come under pressure.

Given the fast pace of devaluation, the central bank is going to have to resort to incredibly high interest rates to lure foreign investors back.

However, most analysts and commentators perceive the Russian situation as something unique. The Government is paying the price for its transgressions in the Ukraine. They argue that the factors affecting the country have no bearing on the rest of the emerging world.

Yet, the Russian situation is like a controlled lab experiment. The important factor here is not what caused the country to lose its access to international capital. Instead, the important observation here is what happens to a country when it loses its access to foreign capital, regardless of the reason.

Moreover, we can see what happens when countries are faced with simultaneous capital flows and negative commodity shocks. The result will be a dramatic fall in the exchange rate.

Traditional macroeconomic indicators, such as GDP growth, the level of international reserves and debt to GDP ratios have no bearing on the severity of a possible devaluation.

The problem is that the rest of the emerging world, especially Latin America, is on the brink of a similar devaluation.

Like Russia, the sharp drop in commodity prices hit the region. Grains and metals posted similar or even larger declines. The result was a serious deterioration of the current accounts. The region's current account gap should crest over US$150 billion this year. GDP growth is under one per cent y/y, but the region still retains good access to the international capital markets. This is how it's been able to manage its currency, so far. International investors still have a voracious appetite for Latin American corporates, and many sovereigns are starting to issue again.

What will happen if there is a confidence shock in the marketplace and investor flees for safety? What if there is some international security event or financial shock? More importantly, what will happen if the Fed decides to move aggressively on the interest rate front?

The result will be an external shock that will rival Russia's loss of access to international capital.

Given that some of the larger Latin American currencies are more than 40 per cent overvalued, then the exchange rate correction could be more than 50 per cent or 55 per cent. Whenever countries experience a maxi-devaluation, the markets tend to overshoot before stabilising at a stronger level.

This is going to play havoc with the region's banks, financial institutions and household balance sheets.

Access to credit will evaporate and debt service will become a problem. Many of the countries also have large housing bubbles that will suddenly burst, as mortgage rates skyrocket.

Russia's problems may be due to its own sins, but the reaction of the ruble may be a sneak preview of what lies ahead for other parts of the world.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities