Why the ‘fragile five’ emerging market currencies have alarm bells ringing again

At the height of the “taper tantrum” in 2013, when the unexpected decision by the US Federal Reserve to start withdrawing monetary stimulus triggered a fierce sell-off in emerging markets, Morgan Stanley coined the term “fragile five” in reference to a group of developing economies that were suffering sharp outflows of foreign capital.

The five countries in question – Turkey, South Africa, Brazil, India and Indonesia – were all running current account deficits and fared poorly in some other areas of financial vulnerability, resulting in steep declines in their local currencies in the second half of 2013. Yet, as investor sentiment towards emerging markets began to improve in 2016, and several of the countries made concerted efforts to address their weaknesses, markets stopped fretting about the fragile five, with some analysts suggesting the term had outlived its usefulness.

They evidently spoke too soon.

On Wednesday, the rupee, India’s currency, sank to a fresh all-time low versus the US dollar, bringing its losses since the start of this year to more than 12 per cent, the worst performance in Asia. The plunge in the rupee has contributed to the recent increase in India’s inflation rate – driven up in part by this year’s sharp recovery in oil prices – which has forced the country’s central bank to raise its benchmark interest rate twice in the past three months.

Meanwhile, the rupiah, Indonesia’s currency, fell to its weakest level since the 1998 Asian financial crisis on Tuesday, having lost 10.5 per cent against the dollar since the start of this year. Indonesia’s central bank has hiked interest rates four times since May and intervened heavily in a bid to shore up the rupiah.

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Other members of the fragile five are in a much worse state.

In Brazil, which holds a crucial yet highly unpredictable presidential election next month, the country’s currency has tumbled 27 per cent against the dollar this year as Latin America’s largest economy struggles to recover from its worst-ever recession.

The rand, South Africa’s currency, which is down 24 per cent this year, fell sharply on Tuesday as newly released data showed that South Africa’s economy fell into recession last quarter for the first time since 2009. As for Turkey, a full-blown currency crisis has sparked fears of a financial meltdown, contributing to the severe strains on the broader emerging market asset class.

The renewed fragility of the five economies has caught many investors and analysts unawares. The current account deficits of nearly all the countries, including Turkey, have fallen as a share of gross domestic product since 2013, currencies are more fairly valued and some of the countries’ central banks, notably Indonesia’s, have built up credibility by tightening monetary policy at the expense of growth.

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Yet the assertion that emerging markets with stronger fundamentals are better insulated from the current sell-off – an argument put forth by my fellow columnist, Neal Kimberley, in a recent article on Asia’s economies – misses the point. The sharp declines in the foreign exchange, bond and equity markets of developing economies over the past several weeks have had less to do with fundamentals than investor positioning.

Sentiment towards emerging markets is deteriorating – and the scope for financial contagion increasing – because of technical factors stemming from a surge in capital inflows over the past two years, especially last year. Data from the Institute of International Finance, which tracks capital flows to more than 50 developing nations, shows that, following China’s surprise devaluation of the yuan in 2015, emerging markets experienced the sharpest rebound in non-resident portfolio flows since the run-up to the 2013 taper tantrum.

Put simply, there is a significant risk of capital flight on a larger scale – particularly from so-called “crossover” investors who are not dedicated to emerging markets – if sentiment continues to worsen.

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As I explained in an earlier column, the recent selling pressure – and the main reason the fragile five as a group have come under renewed strain – stems from this year’s tightening in financial conditions, led by the unexpected surge in the dollar as the Fed turns increasingly hawkish. The outperformance of America’s economy and markets, coupled with the underperformance of Europe and emerging markets, suggests that the rally in the US dollar has further to run.

The good news for emerging markets is that US growth has almost certainly peaked. Bond markets are pricing in a much more dovish Fed next year on the grounds that the economy will slow, which would help weaken an already overvalued dollar. The bad news, however, is that a dovish Fed is likely to be preceded by an overly hawkish one.

The fragile five will remain fragile for some time yet.

Nicholas Spiro is a partner at Lauressa Advisory