Effects From a U.S. Slowdown

So while EM appears to be more insulated from a U.S. slowdown than in the past, and a financial accident is less likely, how might this U.S. slowdown still affect EM and what are the likely consequences?

PIMCO EM sovereign strategist, Ramin Toloui, recently examined the three main channels by which a U.S. slowdown is transmitted to emerging markets, namely: 1) trade, 2) commodity prices, and 3) financial spillovers. Consistent with the highly diverse nature of the countries that make up the EM universe, quite naturally different countries are likely to be affected in different ways.

Countries with the largest export dependence to the United States would feel the greatest impact through the trade channel. As one might expect, countries with higher exports to the U.S. also tend to have growth rates that are more highly correlated with U.S. GDP performance. For example, two of the countries with the highest percent of exports to the U.S. as a percent of GDP (Mexico 25% and Malaysia 20%), also showed among the highest correlations of growth with the U.S. (Mexico 0.64 and Malaysia 0.72).

Commodity prices are certainly another important driver of the outlook for EM. Credit Suisse recently modelled the impact of a 10% decline in the overall commodity basket on EM current account and fiscal balances and found that Venezuela, Russia, Ecuador and Argentina are among the most vulnerable countries, with deteriorations in the current account ranging from 1-3% and, in the worst case, as much as 3.3% deterioration in the fiscal account². Importantly, however, the outlook for commodity prices may be driven less by U.S. growth prospects than in the past, and more by those of China. This assertion is supported by China’s standing as the world’s #1 importer of agricultural commodities and #3 importer of oil in 2005, and by the fact that China was responsible for roughly 1/8th of the incremental export demand for oil over the last five years. Furthermore, a recent Deutsche Bank study suggested that the effect of 1% GDP growth in China and India may have as much as two times the effect on commodity prices coming from similar growth in G7 GDP³.

The financial implications of a U.S. growth slowdown will also affect different EM countries in different ways. While the lower interest rates that accompany softer U.S. growth should be a positive for emerging markets, helping borrowing costs fall, declines in U.S. business prospects tend to increase risk aversion, exerting pressure on credit spreads to widen. Financial flows to emerging markets may also suffer as the slowdown sparks a home bias to capital. Which EM countries are most dependant on access to foreign financing? Taking the 2006 current account balances, and also looking at the coverage ratio of foreign reserves to the total short-term debt plus current account deficits of EM countries reveals Hungary and Turkey as most vulnerable from this angle. These countries have current account deficits hovering around 7% and reserve coverage ratios less than 1.

U.S. Slowdown as an Opportunity?

With the risk of a financial accident in EM that characterised other Fed cycles seemingly well contained, might there be opportunities in EM during this cycle that were not readily available previously?

Assuming a soft landing in the U.S. and given the transmission channels laid out above, it’s likely we’ll see slower economic activity in emerging economies as well. In a mature market context, such a scenario naturally argues for local markets fixed-income exposure, particularly in the front-end of curves. All else equal, as inflation and economic overheating concerns dissipate and slower growth prospects become the baseline, one might expect local bonds to outperform as central banks cut rates to stimulate economic growth.

But is all else ever equal in EM? Two concerns – namely, solvency and policy credibility – have worked against these local markets during past U.S. economic contractions. Historically, high levels of debt have fuelled solvency fears, leading to concerns about inflation and inflationary finance, increasing domestic risk premia, and ultimately forcing countries in times of economic strain to tighten fiscal and monetary policy to restore financial stability and signal policy credibility. Fears of this vicious cycle by international investors have contributed to the sudden stop of capital inflows that have plagued emerging economies in years past.

As such, only in countries that have cemented their policy credibility and solvency, and therefore manage long-term inflation expectations appropriately, could we expect to see central banks moving away from that past, and actually responding to weaker economic conditions by easing monetary policy. Quantitatively, we can identify such countries by looking at measures such as public debt and interest payments as a percent of GDP. But identifying policy credibility is just as important as solvency, though more qualitative in nature.

A country like Mexico may fit this twin bill. The government is embarking on what will likely be 10 years of policy continuity under the Fox and Calderon administrations, bolstered by over a decade of experience running independent monetary policy within the framework of a floating exchange rate regime. In addition, Mexico’s local bond market is large, transparent, well functioning and liquid, with a dedicated buyer base in the form of its domestic pension fund system. Further, total public debt is roughly 25% of GDP, with external debt expected to fall to below 5% of GDP by end 2006.

Investment Implications

So, back to the initial question that plagued me as I went under the dentist’s drill: “Is it safe?” A series of structural changes over the last five years greatly insulate most countries in the EM sector from the risk of a financial crisis. Nevertheless, a slowdown in the U.S. will likely push emerging market external credit spreads wider from historical tights over the coming cycle as commodity prices moderate, competing U.S. corporate credit spreads come under pressure as the business environment weakens, and risk appetite moves off recent highs. Those credits likely to fare best include countries that have minimised external financing needs (Brazil), built significant international reserves cushions (Russia), and have displayed monetary and fiscal prudence (Mexico). In contrast, countries with large external financing needs (Turkey) and large fiscal deficits (Hungary) may face challenges.

Local markets investments may provide the greatest divergence of returns within the EM universe, with those “developing” economies furthest along the road to “developed” market status able to enact traditional policy prescriptions in a slowing global economy and therefore providing enhanced return potential to local fixed-income instruments. Those governments that were unable to build the solvency and credibility platforms described earlier are likely to see a repeat of the volatility that characterised the mid-summer sell-off.

Michael Gomez

Executive Vice President