The recent drop in oil prices is changing the risk profile of Emerging Markets (EMs). Significant adjustments to global financial markets in the second half of 2014 include a large drop in commodity prices, the end of Quantitative Easing (QE) in the US, and a stronger US dollar. These developments, particularly the drop in oil prices, have led to a divergence in EM performance and risks going forward. At this juncture, the most exposed countries are Russia and Ukraine, followed by other commodity producers like Brazil and South Africa.
We have previously identified the EMs most at risk of a balance of payments crisis (see our Economic Commentary dated 6 June 2014). This analysis focused on the Fragile Five (Brazil, India, Indonesia, South Africa and Turkey) EMs that were most severely impacted by the capital outflows following the announcement in mid-2013 of the QE tapering by the US Federal Reserve (Fed). We now have added Russia and Ukraine to our list of EMs that face a material risk of a crisis (owing to the fallout between the two countries as well as the recent drop in oil prices) to make up the so-called Suspect Seven.
Overall, the second half of 2014 has resulted in a significant EM differentiation between those markets that have been able to take the necessary measures to reduce their current account deficits and stabilize their currencies (India and Indonesia) and those that are still struggling to contain the loss of confidence in their economies (Brazil, Russia, Ukraine and to a lesser extent South Africa). Much of the loss of confidence in the latter group has been driven by lower global commodity prices, including oil.
The improvement in financial market sentiment towards the Suspect Seven has occurred despite a steady downward revision in the outlook for these economies, with the main exception of India. According to Bloomberg consensus, real GDP growth is now expected to be 5.4% in 2014 up from 4.7% expected in June. Indonesia is the only other Suspect Seven expected to grow by over 5% in 2014.
Lower oil prices have been a key differentiator of EM performance during the second half of 2014. Brent oil prices peaked in mid-June at USD115 per barrel. Since then prices have fallen over 30% to around USD80 currently. Falling oil prices have helped improve external balances in India and Indonesia and their governments have also taken the opportunity presented by lower oil prices to increase fuel prices and reduce their subsidy bills. The new Indian prime minister, Narendra Modi, announced in mid-October that the government would stop fixing diesel prices, eliminating half of total fuel subsidies, which cost the government around 9.4% of the budget last year. The new Indonesian president, Joko Widodo, announced in mid-November a 30% increase in fuel prices, which follows a 33% increase in June 2013. Fuel subsidies are expected to reach around 19% of the Indonesian budget this year.
Russia has been the hardest hit by falling oil prices—the exchange rate has weakened 34.9% since the end of June as falling oil prices have exacerbated weaknesses relating to international sections associated with tensions in Ukraine. Ukraine itself is in a particularly dire situation. The economy is now expected to contract by 7% this year. Sovereign default was narrowly averted in May with an agreement for external support from the IMF and other donors totalling USD27bn. International reserves fell to just USD12.6bn from USD16.3bn at end-September. The central bank gave up on efforts to defend the currency in early October and is now running short of reserves. Without continued external support, Ukraine is likely to experience a sovereign default.
In Brazil, falling oil and commodity prices have also added to concerns about political uncertainty that stem from the October presidential elections and delays to appointing a new government. This has led to a sharp depreciation of the Brazilian real of 13.9% since the end of June 2014.
The outlook for South Africa has deteriorated slightly during the second half of the year as the economy is predominantly reliant on commodities. Falling commodity prices have led to a downward revision in consensus real GDP growth forecasts from 1.9% in June to 1.5% currently. The small weakening of Turkey’s currency since June has mainly been driven by a deterioration in the security situation in neighbouring countries. Turkey faces some major challenges with a current account deficit expected to be over 5% this year, although, as a net oil importer, the drop in oil prices should help.
Another important factor that has supported EMs is further unexpected monetary easing in China and Japan, which has eased global liquidity conditions. Previously, financial markets had been concerned about the ending of QE in the US in October. However, the People’s Bank of China unexpectedly cut lending and deposit rates on 24th November. Additionally, the Bank of Japan surprised markets by expanding its QE programme at the end of October with much of the additional liquidity expected to flow to EMs in search of higher yields.
Overall, recent developments in global financial markets have helped stabilise some of the fragile EMs that were previously thought to be at risk. However, recent developments, including lower oil and commodity prices, have been less positive for commodity exporting countries, particularly Russia and Brazil, which are suffering as a result. Political tensions in Ukraine are pushing the country close to the brink. If Ukraine goes down, contagion could further destabilizes Russia.