By Jake Moore, emerging-market currency strategist with Barclays Capital
London--Emerging financial markets have experienced renewed drag in recent
weeks, triggered by fears of higher U.S. inflation and rates. We believe
that the U.S. Federal Reserve will unwind over time its 75 basis-point
insurance policy, taken when the world was rocked by market turmoil last
year. After examining the factors underpinning this year's emerging-markets
rally, we conclude that a likely U.S. rate hike will not turn conditions
outright negative for markets trying to shake off the crisis in 1998. U.S.
rates have a significant impact on all emerging markets because they affect
global capital flows. Higher U.S. rates push up the world interest rate,
reducing global liquidity and the flow of high-powered money to emerging
markets. Moreover, a higher world rate can cause capital to leave emerging
markets until their rates adjust to adequately reflect investors' extra risk
premium. Their currencies may also need to adjust, which explains the
depreciation of the Mexican peso in the last two weeks, for example.
Asian bourses are being buoyed by benign liquidity conditions, and a U.S.
tightening may take some of the shine off the Asian reflation rally. But
domestic conditions will still be supportive of good financial-market
performances. These conditions include: healthy Asian liquidity as local
financial institutions invest in financial rather than real assets; Asian
rates remaining accommodative; and fiscal pump-priming to support expansion
of demand and better-than-expected headline growth numbers. Latin America,
on the other hand, is particularly vulnerable to a U.S. rate hike and
reduced global liquidity. Trade and especially capital links between the
U.S. and Latin America are relatively close, and a U.S. tightening can
damage investor sentiment, thanks to memories of the 1980s debt crisis and
the 1994 peso crisis. The debt crisis was largely the result of U.S. rate
hikes at a time when Latin American debt obligations were mainly on a
floating-rate U.S. dollar basis. The peso crisis was the result of growth
and interest rate concerns. Within Latin America, Argentina and Mexico are
most at risk.
Argentina is threatened because of its currency-board exchange-rate regime.
A currency board necessitates a lack of sovereignty over monetary policy.
Instead of the exchange rate adjusting to reflect differing yields,
Argentine rates increase when U.S. ones climb. This poses two risks. First,
the Argentine banking system experiences difficulties, and credit risk
increases associated with the rate hike. Second, higher rates are the last
thing the Argentine economy needs. Economic growth in Argentina is slowing
sharply. Industrial output was down 10.8% on the year in April, and we
expect that gross domestic product will slide about 2% on the year in 1999.
Recent price data also confirms that real interest rates are already
climbing. The economy has started deflating, with consumer prices falling by
1.2% on the year in May. Under these circumstances, the country needs
stimulative rather than restrictive monetary policy.
Higher U.S. rates are also likely to further weaken the Mexican peso, making
it ease from its current level of 9.5 pesos to the dollar eventually back
toward 10 pesos. But the major concern will be Mexico's possible slide into
recession. Its economy is increasingly geared toward developments north of
the border, so investor sentiment could slump in coming months on fears of
slowing U.S. growth.
However, we believe that such fears will prove unfounded. U.S. expansion is
likely to continue at a robust pace this year, with gross domestic product
up 4.1% on the year, underwriting a recovery in the fundamentally healthy
Mexican economy. This will provide conditions for asset-market appreciation
and currency stability over time. U.S. rates may climb, but these moves will
be small in comparison to those in the 1980s. Moreover, Latin American
lenders and borrowers have learned the lessons of the debt crisis, with a
greater utilization of fixed-rate bond borrowing. These two factors reduce
the chances of widespread credit difficulties across the region. For
emerging markets as a whole, conditions may not be as beneficial as those in
the last nine months, but they will still accomodate capital flows to
emerging markets.
Jake Moore is emerging-market currency strategist at Barclays Capital, the
investment banking division of the Barclays Group, London.
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