LONDON — Emerging economies’ debt in euros has shot to record highs thanks to European Central Bank (ECB) largesse, and yet an approaching end to this generosity won’t necessarily inflict the kind of pain that markets once suffered at the hands of the US Fed.
The ECB’s intention to start winding up its €60-billion-a-month stimulus program for the euro zone economy has revived bad memories of when the Federal Reserve tried to signal something similar in 2013.
That led to the “taper tantrum” when investors took fright at the prospect that the ultra-cheap dollar funding they had grown used to would taper away.
While the ECB will proceed cautiously with its own tapering, the risk is that it could derail an emerging market (EM) rally.
UBS strategist Manik Narain, however, argues that withdrawing quantitative easing (QE) in the euro zone won’t hurt so much as the dollar process.
“ECB tapering will have an impact but it’s definitely the lesser of the two evils,” he said.
While governments, companies and consumers in emerging economies have binged on cheap euro borrowing for the past two-and-a-half years, the total remains modest compared with their dollar debts, Mr. Narain pointed out.
No central bank is finding it easy to withdraw policies that helped to keep Western economies afloat after the global financial crisis. Investors are awaiting word from ECB President Mario Draghi, who will speak at a central bankers’ meeting in the United States this week, on how he proposes to engineer a gradual end to the era of mass bond buying and negative interest rates.
The important thing is to avoid a repeat of the taper tantrum of four years ago. This wiped half a trillion dollars off MSCI’s emerging equity index in three months, raised countries’ borrowing costs by an average one percentage point and pushed some emerging currencies down by as much as 20% against the dollar.
Now it is the ECB’s turn.
Mr. Draghi will deliver no new policy messages during this week’s conference at Jackson Hole, sources say.
However, expectations are high that he will tackle the issue at one of the ECB’s policy meetings next month or in October.
Under Mr. Draghi, the ECB has pumped more than €2 trillion ($2.35 trillion) into the global financial system. His first hint in June that tapering might be coming pushed the MSCI’s emerging equity index down two percent over the following week.
On currency markets, Turkey’s lira and South Africa’s rand fell sharply, not only against a broadly stronger euro but also the dollar. Investors were unsettled by the prospect of higher euro zone bond yields dragging up US borrowing costs in their wake.
Emerging markets have achieved stellar gains this year but investors using the euro have largely missed out due to the currency conversion.
The dollar has fallen five percent versus a basket of emerging currencies tracked by UBS, but the euro is up six percent.
Only four emerging currencies — those of Poland, the Czech Republic, Hungary and Mexico — have strengthened against the euro this year.
Developing economies are more exposed to the euro than any other time in history.
Their euro-denominated debt — including bonds and bank loans — has ballooned by almost €100 billion over the last seven years to around €250 billion, according to data from the Bank for International Settlements.
In Mexico alone, debt in euros has quadrupled since 2010 to over €42 billion.
But even then overall emerging borrowers’ euro debt is dwarfed by the $1.7 trillion they owe in dollars. So they are much more susceptible to movements in US government bond yields than those on the euro zone benchmark, German Bunds.
“The bulk of EM external debt is in dollars rather than euro and the EM corporate sector gravitates towards dollar funding… so a 50 basis-point move in Treasuries matters a lot more than 50 bps move in Bunds, other things being equal.”
European exposure to emerging stocks and bonds also lags the United States.
UBS research suggests more than 60% of EM carry trades — borrowings in cheap developed economy currencies invested in higher-yielding emerging currencies — are denominated in dollars, Mr. Narain said.
As of June 2016, euro zone investors held about €407 billion worth of emerging currency-denominated debt, according to calculations by Bank of America Merrill Lynch (BAML).
But this is little changed from December 2013.
David Hauner, head of emerging markets cross-asset strategy at BAML, says European investors do not appear to have moved heavily into emerging debt during the ECB’s quantitative easing (QE) years.
In fact, most moves happened during the Fed’s own bond-buying from 2009 onwards and when the ECB started its earlier program of showering banks with unlimited, ultra-cheap funding.
A quarter of this money was invested in Polish, Hungarian and Czech debt, the data shows.
Turkey accounts for another €42 billion, while Brazil and Mexico had €39 billion and €74 billion respectively.
Analysis from the Institute of International Finance supports that view. It estimates $200-300 billion flowed to emerging stocks and bonds annually during the peak years of the Fed’s bond buying in 2012-2013. But by last year, when the ECB’s QE peaked, flows declined to $100 billion.
The view that emerging market investing remains a dollar story is supported by a Deutsche Bank study of an equally weighted euro-dollar basket versus 12 emerging currencies. This showed that emerging currencies tended to fall an average 0.6% in months when the dollar strengthened, whereas they rose by 0.4% against the basket during times of euro strength. “These results suggest that if external conditions remain relatively benign, the current emerging currency appreciation cycle has more room to run,” Deutsche’s Gautam Kalani added.
At BAML, Mr. Hauner says euro-based investors earn a better yield premium by investing in emerging markets than those using the dollar. “Unless dollar strength is extreme, euro-based investors do better in EM than dollar-based investors, as euro/dollar removes much of the volatility in emerging currencies,” he said. “In a nutshell we are not very concerned about this.” — Reuters