The good, the bad and the ugly – Ashmore’s Dehn on emerging markets

Jan Dehn, head of research at Ashmore, discusses the latest EM survey releases and policy reforms

Ukraine
Over the past week the level of political noise in Ukraine rose to levels last seen during the Orange Revolution as many Ukrainians voiced their unhappiness at the government’s rejection of a trade pact with the European Union. The rejection of the trade pact was seen as a sign that Ukraine is turning towards Russia’s Eurasian Union. Many Ukrainians fear that closer ties with Russia would mean a sacrifice of the independence achieved in the Orange Revolution.

In our view, the government is playing a different game. It does not want to pick sides. Picking Europe would mean facing tough upfront IMF reforms. Picking Russia would mean losing key gas storage assets. Ukraine wants to maintain its independence, while benefitting from the fact that neither the European Union nor the Russians want to ‘lose’ Ukraine. But the stretched state of Ukraine’s finances means that the government’s only credible course of action is to play the ‘crisis card’; that is giving the impression that the country is just about to commit to one side or the other. This makes for a lot of noise and it is obviously not a risk free strategy.

We think it is likely that Ukraine will extract concessions from both sides, while at the same time pursuing financing options from third parties, including private sources. In this context, we note that Prime Minister Yanukovich visited China last week.

Thailand goes to the polls
The political unrest is specific to Thailand and merely the latest round in a repeating cycle. Thailand’s divisive politics derive from big divisions in society at large between higher income urban dwellers and a larger group of pro-government rural-based low income voters. These socio-economic divisions are not likely to go away, even with elections, in our view.

In the current upheaval, opposition groups have demanded the dissolution of the legitimately elected and majority supported Thaksin administration, which they accuse of acting on behalf of exiled former Prime Minister Thaksin Shinawatra. The government has now met this demand, probably because it believes it can win. This is a positive development, although there is no guarantee that fresh elections will bring material change. The military has in the past stepped in when the level of instability in civilian circles rose to unacceptable levels.

Despite Thailand’s very unconventional political dynamics Thailand’s tourism and other industries have been able to thrive through the episodes of political volatility in the past. We expect the same to be the case this time. Government economic policy has tended to be very conservative. We expect growth to remain modest in Thailand next year due to the political situation. The upside would come in the event of a restoration of political stability, which could usher in a go-ahead for a massive program of infrastructure investment, which is currently held up by political and legal obstacles.

India and Indonesia – turnaround in balance of payments
Has the Fragile Five become the Fragile Three? Brazil, Turkey, South Africa, Indonesia, and India were labelled disaster zones in 2013, though none of them are in crisis. All five, however, required macroeconomic adjustment after self-inflicted excess domestic demand problems and resulting trade deficits.

Of the five, however, Indonesia and India went on to undertake material policy changes intended to restore external and domestic economic equilibrium. These efforts now appear to be bearing fruit in our view. India published Q3 balance of payments data last week and the improvement is shocking. India’s current account deficit shrank from USD 21bn (5% of GDP) in Q2 to USD 5bn (1.2% of GDP) in Q3. Not only did imports decline but exports rose too, precisely the type of economic reaction one would expect from a successful policy intervention. India is now on track to improve its overall balance of payments position by a factor of two in just one year.

Meanwhile, Indonesia’s trade balance swung into outright surplus in October. The market expected a deficit of USD 775m, but the number was a surplus of USD 42m, which was achieved as a result of strong export growth and contracting imports. Both improvements are probably attributable to the adjustment policies including the reduction of energy subsidies, dropping the soft peg and hiking policy rates undertaken by the government since the outbreak of EM pessimism in May of this year. Consistent with this interpretation was the declining headline inflation print for November. Inflation was lower than expected at 8.4%, while core inflation was largely flat at 4.8% yoy. The big gap between headline and core inflation is due to the removal of energy subsidies by the government. This pushes headline inflation temporarily higher, but then creates very favourable base effects on inflation 12 months out. As an aside, Malaysia also made significant further reductions in fuel subsidies in the past week as the fiscal consolidation continues.

Focus on Fiscal in Brazil
Brazil’s primary surplus shrank from 1.6% of GDP in September to 1.4% of GDP in October on a 12 month cumulative basis. Higher than expected spending accounted for the deterioration, but the additional expenditure mainly consisted of one-off outlays to satisfy court judgements. Besides, seasonal factors are likely to boost revenues in the coming months, so the fiscal picture may improve at the margin in the next few months, in our view. Even so, the government is likely to miss its 2.3% of GDP primary surplus target this year by some 0.7% of GDP, discounting special items.

The silver lining is that Brazil is still running a significant primary surplus and the fiscal numbers are deteriorating from a position of considerable strength. Total (private and public) foreign debt as a percentage of GDP is just 22.5%, net general government debt as a share of GDP is just 35%, and Brazil has USD 375bn in FX reserves.

The real culprit behind the worsening fiscal numbers is the broader growth picture. The economy only expanded at a pace of 2.2% yoy in Q3, which was below expectations. Details showed that the softer than expected number was due to declining investment (-2.2% qoq) and falling net exports (-1.4% qoq). Consumption rose 1.0% qoq. This means that Brazil now looks set to grow about 2.0% in 2013. This is more than twice as fast as last year’s growth rate, but a 2% handle for growth is disappointing for an EM country.

Brazil’s growth problems – and by extension its fiscal problems – are entirely self-inflicted. They have nothing to do with the economic problems in the global economy or in some other EM economies. The government inherited an extremely strong economic position from the previous administration, but greater intervention in prices, exchange rates, and the erosion of central bank monetary policy independence have sharply undermined business confidence.

Turkey turns
Inflation in Turkey surprised to the downside in November, clocking a rise of just 0.01% against expectations of 0.5% monthly inflation. This reduces the yoy rate from 7.7% in October to 7.3% in November. Core inflation also declined to 7.1%. Inflation is expected to fall further in Q1 due to base effects from last year’s hike in tobacco prices. The benign inflation print is extremely important, in our view. It will allow the central bank to keep rates in check, and thereby avoid hurting domestic growth at a time of considerable external head winds for Emerging Markets and Turkey in particular.

The main focus in Turkey going into 2014 is going to be the local elections scheduled for March 2014. These elections are a key test for the popularity of Prime Minister Erdogan and the ruling AK party. A strong showing is likely to result in business as usual for the government, but a poor showing could trigger a broad range of changes, including monetary policy, the election schedules, and in the leadership of the AK party.

Given the importance of the March elections we think the central bank will try as far as possible to deliver economic stability in Turkey. This will translate, into stable rates and a weaker currency. The main risk to this view is that the US Federal Reserve signals a delay in tapering. A delay in tapering would probably usher in a decent rally in TRY, which in turn could lead the central bank to cut rates.

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