Grexit may make matters worse for emerging markets
As if emerging markets (EMs) did not have enough problems to contend with, the growing threat of a Greek exit from the eurozone (“Grexit”) risks further undermining sentiment towards the fragile asset class.
Following last weekend’s unexpected breakdown in talks between Athens and its creditors over the terms of financial aid and the imposition of capital controls to avert a collapse of the Greek banking sector, investors initially dumped so-called “risk assets” and fled to the perceived safety of US and German government debt.
On Monday, EM equities fell 2 per cent, their sharpest fall in almost seven months, leaving developing stocks down more than 3 per cent in June. The currencies of developing economies were also hit, with the most vulnerable ones, such as the Turkish lira and the Russian rouble, leading the declines.
For the first time since Greece came close to crashing out of the eurozone in the spring of 2012, the spectre of financial contagion resurfaced.
Yet while Greek premier Alexis Tsipras’s surprise decision to call a referendum on the latest measures proposed by creditors (and, more importantly, actively campaign for a “no” vote) has increased the odds of a Grexit, the political situation in Greece remains fluid, with a number of potential outcomes still possible.
The mood in the markets can best be described as volatile as opposed to panic-stricken - at least for the time being.
Indeed already on Monday there were signs that the initial sell-off was abating. Having sank 2 per cent in early trading, the euro finished the session up 0.2 per cent against the dollar and has had its best quarter in four years.
More importantly, Spanish and Italian bond yields - which are seen as the most accurate gauge of investor anxiety about the likely fallout from a Grexit - spiked sharply only to fall back again. With yields on 10-year Spanish and Italian debt currently standing at 2.2 per cent - compared with the 6-7 per cent range at the height of the eurozone crisis and the 15 per cent level at which their Greek equivalents now stand - it is clear that contagion is being contained.
This begs the question: does Greece matter to EMs if even Southern Europe’s financial markets are proving resilient?
There is no question that the financial and economic linkages between Greece - which accounts for a meagre 0.3 per cent of global GDP and less than 2 per cent of eurozone economic output - and EMs are negligible. The only developing countries directly at risk from a disorderly Grexit are Bulgaria, Romania and Serbia whose Greek-owned banks are heavily dependent on funding from their parents.
However, as JP Morgan rightly notes, while Greece is not “an EM crisis, a risk-off environment will likely affect EM.”
Given the plethora of economic and financial vulnerabilities in EMs and the fragility of sentiment towards the asset class - EM equity funds have already suffered more than US$22 billion in outflows this year, 75 per cent of last year’s total redemptions – a disorderly Grexit (or even the growing likelihood of one) could increase investors’ sensitivity to EM risks, leading to a further deterioration in sentiment towards developing economies.
The EMs most at risk are the usual suspects: economies which are heavily reliant on speculative inflows of foreign capital to fund their current account deficits. Turkey and South Africa, both of which run large external deficits, are especially vulnerable - not least given the fact that the countries’ central banks have been reluctant to raise interest rates for fear of crimping growth.
Yet a sharp Greek-driven deterioration in sentiment could also prove damaging to China whose increasingly volatile equity market entered technical “bear market” territory on Monday before bouncing back sharply on Tuesday.
While the recent 20 per cent fall in the Shanghai Composite Index is attributable to the unwinding of so-called “margin financing” following a spectacular bull run, an escalation in Greek-fuelled tensions could throw the disconnect between a liquidity-fuelled stock market and China’s deteriorating economic fundamentals into sharper relief.
On the other hand, a disorderly Grexit would provide an additional argument for the US Federal Reserve to delay the timing of its first hike in interest rates since 2006, potentially limiting the fallout.
Some market participants even believe a Grexit could prove to be a cathartic moment for the eurozone, helping shore up the rest of Southern Europe. If this sounds too complacent, it is because it probably is. Vulnerable EMs can ill afford a break-up of the eurozone.
Nicholas Spiro is managing director of Spiro Sovereign Strategy