Many fixed income, currency and equity markets in central and eastern Europe have come under sustained selling pressure in January. There are various reasons for this, but clearly the catalyst has been the start of tapering by the US Federal Reserve, as well as some nervousness among investors about a slowdown in Chinese growth. Below, we outline where we believe the key areas of vulnerability (and strength) lie. Overall, we believe that the heavy January selling will not last for most countries, and emphasise that central and east European markets are in a much stronger position than during previous times of crisis, such as the late 1990s.
The first talk of tapering in May 2013-a reduction in the amount of debt securities that the Fed buys each month-caused a sell-off in many emerging markets during the middle of last year. However, for most countries in central and eastern Europe this was reversed in the later part of 2013 (Turkey was an exception). Since the Fed started tapering (it is now buying US$65bn of assets per month, compared with US$85bn per month until December 2013) selling pressure has resumed, and more savagely. This was exacerbated by the release of weak Chinese manufacturing data in January, which increased investor concerns about the growth outlook for the world's second-biggest economy.
Since the global financial crisis of 2008-09, monetary stimulus by many of the world's most influential central banks, and robust Chinese demand, are two of the main factors that have underpinned the global economic recovery. How well assets in emerging markets-including those in central and eastern Europe-deal with the drawdown of the former, and the potential for a lower contribution from the latter, is now clearly at the forefront of investors' minds.
Overall, although selling pressure has been quite pronounced, we see a great deal of differentiation in how assets in central and eastern Europe have fared so far, indicating that recent market moves are not reflective of a general dash for the exits on the part of investors. This implies that those with good fundamentals will be rewarded, and creates a powerful incentive for reform in those countries that do not.
Several trends have been apparent during the January sell-off:
- Generally, apart from the obvious example of Ukraine, the countries worst affected have been Turkey, Russia and Hungary, and to a lesser extent Romania.
- On some metrics Croatia has also suffered, while Poland and (particularly) the Czech Republic look much better positioned.
- Equity markets have been hardest hit in Russia and Turkey; currencies in Russia, Hungary and Turkey; and sovereign debt in Russia, Hungary and Romania.
- The response from central banks and governments has been uneven, although their room to influence events in the near term is limited.
Based on this, we believe that the main factors driving the uneven impact of tapering are investor perceptions of political risk and policy creditability, as well as (low) interest rates. So far it appears that markets have been fairly indiscriminate in terms of the health of countries' external accounts, fiscal positions, debt loads and economic growth.
What is driving the sell-off?
Examining the countries where the biggest falls have taken place-Turkey, Russia, Hungary and Ukraine-it is not immediately clear why they have been more badly affected than other states. Clearly Turkey's large external deficit and reliance on short-term portfolio inflows and Russia's poor growth outlook are important factors for these countries. In Turkey we estimate that foreign-exchange reserves cover less than 100% of external debt, compared with an average of over 300% for emerging markets as a whole. However, traditional indicators of creditworthiness indicate no clear pattern between the four countries. Of the central and east European countries examined, Russia has the highest foreign-currency reserves/import cover ratio; Russia and Hungary have the largest current-account surpluses; and Russia and Turkey have the lowest external debt ratios.
Two important factors are common among most or all of these four countries, however:
- Political risk
This is a much more significant issue in these four countries than in the others. Ukraine has seen months of increasingly violent unrest, and we do not rule out an intensification of the conflict between the government and the protesters. Turkey saw significant anti-government protests in 2013, and since mid-December the prime minister, Recep Tayyip Erdogan, has been engaged in a destabilising power struggle with former allies-supporters of a US-based cleric, Fetullah Gulen, who include influential members of the police, the public prosecution service, the judiciary and the ruling party. For Russia and Hungary there is less chance of large-scale unrest, but there are serious concerns over the politicisation of key institutions.
- Monetary and fiscal policy credibility
Elevated political risk is linked to policy credibility, particularly regarding the independence of the central bank and monetary policy, which are areas of vulnerability for all four countries. In Turkey, the prolonged delay in raising interest rates (key rates were hiked by 425-550 basis points after a central bank meeting on January 28th, in response to the lira's slide), and the bank's perceived susceptibility to government interference have undermined the credibility of the country's monetary policy framework. In Russia, although monetary policy credibility is greater, we believe that the central bank's willingness to allow the rouble to float more freely has been an important factor driving the sell-off in the currency.
In Hungary, the central bank-which is now headed by Georgy Matolcsy, a close ally of the prime minister, Viktor Orban, and previously the economy minister in the Fidesz government-has cut its main refinancing rate by a cumulative 415 basis points since mid-2012. This has drastically reduced the interest rate premium over the US base rate (as well as the euro and regional peers), reducing the incentive for investors to hold the forint. Monetary easing on such a scale has been made possible by low inflation, although to a significant extent this has been caused by government-mandated energy price cuts (of around 20% in 2013). Core inflation-which strips out energy and food prices-remains well above the central bank's 3% target rate.
The sharp sell-off for the forint since mid-January indicates that investors are less willing to tolerate the currency's lower carry premium now that tapering is under way. However, unlike in Turkey, there has been no monetary response, with Mr Matolcsy indicating plans to keep cutting the benchmark rate (this will lead us to revise our view that the weakness of the forint would be limited this year-we had expected concerns over foreign-currency loans to lead the central bank to stop cutting the benchmark rate if serious forint weakness emerged).
In Ukraine the fixed peg regime has remained a key tenet of monetary policy, despite weak foreign demand and falling steel prices. This has dampened economic activity, exacerbating the widening of the current-account deficit and leading to a rapid fall in reserves. In both Turkey and Hungary, upcoming elections create further political risk concerns. Hungarians will go to the polls in April, and Turkey has elections in both March and August.
A third country suffering from a lack of policy credibility is Croatia, largely because of developments on the fiscal side. We estimate that the budget deficit widened to the equivalent of 6.1% of GDP in 2013, from 3.3% in 2012. The Croatian sovereign was downgraded to BB by Standard & Poor's (S&P), a ratings agency, on January 24th, pushing it further into non-investment grade status. On January 30th the government released new budget plans, laying out how it will cut the deficit to 4.6% of GDP this year, in line with entry into the EU's excessive-deficit procedure (EDP) for countries running fiscal deficits larger than 3% of annual output. However, we do not believe that the measures on the expenditure side are enough to reassure markets that the government is serious about fiscal reform.
Sustained weakness remains unlikely for most
There is clearly a potential for the sharp sell-offs of recent days to become self-sustaining. The weakening of assets can trigger stop losses, leading to further selling pressure and the triggering of new stop losses, resulting in more significant falls in emerging-market assets. However, at present this is not our core view.
Overall, fundamentals in emerging markets are much better than in previous periods of volatility. Apart from Ukraine, all the countries discussed here have healthy levels of foreign-exchange reserves relative to imports, and none except Turkey and Ukraine have significant current-account deficits. These factors make them much better able to withstand sustained capital outflows. Only Hungary and Croatia have public debt loads close to 60% of GDP (the EU limit), and only Croatia and Ukraine have serious fiscal issues. Moreover, in most countries the monetary and political authorities have significantly more room to take action to stem weakness than in previous bouts of emerging-market crisis. Seasonal trends are also likely to provide support-in Russia the current account should strengthen in the coming months, lending support to the rouble.
In addition, there will be some opportunities in the crisis. One obvious point is that the weakness of emerging markets' currencies-where not so long ago the concern was about many of them being too strong-will improve export competitiveness, as well as lifting inflation, a positive for countries that have moved perilously closed to deflation in recent months. Moreover, market pressure may well force fiscal reform in countries where it is required, notably Croatia.
Differentiation will continue
One key point for central and eastern Europe is that emerging markets can clearly no longer be seen as a single asset class. Some of the countries examined here-notably the Czech Republic and Poland-are likely to perform more like developed markets as the Fed's monetary stimulus is unwound, whereas others-Turkey, Ukraine and Hungary in particular-continue to demonstrate some of the traditional signs of emerging markets' vulnerability, and may well be in for further currency weakening. Croatia and Russia also look susceptible to further weakness on some measures-the rouble will be less supported by central bank intervention than previously, and investors remain concerned about political risks; while the Croatian government is likely to have to do more on the expenditure side of the fiscal accounts to assuage investor concerns. Tapering was always likely to have an impact, given the scale of the Fed's asset purchases in recent years. However, whereas the past few years have been marked by a strong and fairly indiscriminate compression of global yields, the exit from monetary stimulus by the Fed is likely to see a great deal more differentiation on the part of investors.
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