Emerging Markets Get a Wake Up Call From the Fed…

Just as the PBoC shocked markets last month (and perhaps itself) by engineering a record spike in interbank rates to instill some lending discipline, the RBI last week reversed course on easier policy as the INR broke the 60 level versus the USD, amid an ominous rally in oil prices. Growing concerns about bank asset quality and a looming surge in loan write-offs set against the backdrop of a structural economic slowdown is a narrative as relevant to India as China right now, although the key difference is in the huge divergence in their currency performance and capital flows. In real effective terms (i.e. trade weighted and relative inflation rate adjusted), the RMB has outperformed the INR by about 25% since early 2010, and the impact of FX moves as much as funding costs on sector selection has been critical in both countries (with an ongoing profit windfall for Indian exporters).  Indian bank NPLs reached 3.5% per at the end of the last financial year, with “restructured” assets now accounting for maybe 6% of loans. According to Fitch, the combination of bad and restructured debts will reach just under 12% of loans, or 3.5trn Rupees ($60bn), by next April, a level that has nearly doubled in just two years.

Short of reversing course and following Indonesia in raising the repo rate to stem the currency slide, this was a very aggressive attempt to draw a line at around 60 INR to the USD. The repo rate has been cut three times this year and was held steady at the RBI’s last monetary policy meeting in June. Given the risks of further global portfolio flow volatility, the rate cut cycle is almost certainly over for this year at least. In a statement published last week, the RBI said: ‘The market perception of likely tapering has triggered outflows of portfolio investment, particularly from the debt segment. Countries with large current account deficits, such as India, have been particularly affected despite their relatively promising economic fundamentals.’ India’s current account deficit was 4.8% of GDP at the end of the fiscal year to March, or $88bn, up from $78bn a year earlier.

Since the Fed suggested its Q4 exit strategy, foreign institutional outflows from the equity market have reached almost $3bn (although still up a net $12bn YTD) and from debt markets over $5bn, while the rupee has depreciated by about 10%. As in Indonesia, the 10-year yield has broken 8% and interest rate sensitive equities from real estate to banks have been hit hard. The proposed liberalization of FDI limits in important infrastructure sectors such as telecoms is a minor positive against this backdrop, and we are going to see a surge in government expenditure pre-election (spending is set to rise 16% y/y in the current FY to end March 2014, versus 9.7% in the last) but the situation remains dangerous until the currency/current account stabilize.

The RBI raised its Marginal Standing Facility interest rate (the cost of borrowing from the RBI using its emergency liquidity mechanism) by two percentage points to 10.25%, bringing it to 300 bps above the repo, its main policy rate. The RBI’s Bank Rate – the standard rate at which it lends to Indian banks was also raised from 8.25% to 10.25%. Funds available under the RBI’s liquidity adjustment facility – which helps banks adjust daily mismatches in liquidity at a softer rate of 7.25% – have been limited to about 750bn rupees ($12.6bn). On the other side of the world, India has had a glimpse of what a reformist, ambitious government can do.

Mexico, which is already the biggest beneficiary of China’s deteriorating manufacturing competitiveness as reflected in US export market share and has been tackling rampant corruption (for instance, in the notorious teacher’s union), unveiled an investment plan to upgrade the country’s key infrastructure, which including investments from the private sector, could hit 4trn pesos ($314bn) between now and 2018 or almost a third of Mexico’s annual GDP. As I’ve long highlighted, the ‘rising tide lifting all boats’ macro scenario for GEM via the positive terms of trade boost from China via commodity prices and the resultant capital inflows is over, the quality of governance matters more than ever for investors, as evidenced by the execution of structural and institutional reforms to boost productivity and domestic demand. Mexico and China are voluntarily starting down that road, Indonesia and India are being forced to by markets, but with questionable technocratic competence to deliver while Russia and Brazil look hopelessly behind the curve. This is all an overdue wake-up call for complacent emerging market policy makers and indeed investors in the asset class.