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 As even the relatively robust economies of Mexico and Poland now
feel the heat from disparate flashpoints from Turkey to Argentina,
there are growing doubts that emerging markets have built any
immunity to such contagion.
The wildfire engulfing the developing world is starting to look very
like the currency runs of the past, such as the Asian, Russian and
Latin American collapses that began in 1997.
Dominic Rossi, Global CIO for equities at fund manager Fidelity,
likens the current wave of plunging currencies, equities and bonds
to watching an old film — one in which some of the biggest emerging
markets could feature.
"We've seen this movie before," he said. "One emerging country after
another gets left stranded on the shore as the tide goes out. The
weakest ones first, Argentina and Turkey, soon to be followed by
Brazil, Russia and others."
Emerging markets have been inflated in recent years by huge amounts
of cheap cash created by the U.S. Federal Reserve, much if which
found its way into developing economies in the hunt for better
returns. With the Fed scaling back the program, that flow is
reversing and the currencies of countries with the biggest economic
and political problems — notably Argentina and Turkey — are diving.
Investors' behavior may not have changed all that much from during
the past crises, even though many emerging economies now have more
flexible currencies and trillions of dollars in foreign exchange
reserves. There are three main reasons why these markets could again
suffer the capital flight that plagued them during the 1990s.
First is the scale of money that has moved to developing markets
over the past decade and now dwarfs the sums which fled in panic 15
years ago.
Secondly, lending into emerging markets has increasingly been
through bond markets, rather than in the direct bank loans that
dominated previously and which involved longer-term relationships
between banks and the firms and countries.
Thirdly, the emergence of index-tracking Exchange Traded Funds (ETFs)
over the past decade has arguably increased the indiscriminate
nature of emerging market inflows, leaving them ever more vulnerable
to lockstep withdrawals.
So for all the transformation of emerging economies, their higher
credit ratings, superior balance sheets and infrastructure,
investors still tend to lump developing countries together when
markets sell off, Goldman Sachs CEO Lloyd Blankfein told Reuters
Television.
Blankfein said people who carefully weighed one investment against
another when entering a market, were much less discriminating when
departing in haste.
"When times are good emerging markets are like a credit business,
name by name," he said. "When things get bad, forget the names, it's
a macro event. Forget the differences, they are all emerging
markets."
TIDAL WAVE
Emerging markets have attracted about $7 trillion since 2005 through
a mix of direct investment in manufacturing and services, mergers
and acquisitions, and investment in stocks and bonds, the Institute
for International Finance estimates.
JPMorgan estimates outstanding emerging market bonds at $10 trillion
compared with just $422 billion in 1993. Assets of funds benchmarked
to emerging debt indices stand at $603 billion, more than double
2007 levels, it said, and over $1.3 trillion now follows MSCI's main
emerging equity index.
Mutual fund data from Lipper, a ThomsonReuters service, shows that
in the past 10 years net inflows into debt and equity markets was in
the region of $412 billion.
Significantly, there have been few major hiccups in emerging
economies in that period, and only in the global crisis year of 2008
and in 2013 were there any net redemptions, Lipper showed.
The result, many say, is a recipe for fund redemptions snowballing
when returns fall below a certain level. Losses in one or two markets can leave managers with no choice but
to liquidate other positions to protect the fund's net asset value (NAV),
the main indicator of how profitable a fund is relative to its
assets.
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 But emerging markets' inherent volatility may have been
exacerbated by the explosion in popularity of ETFs, many people
believe. Assets of emerging equity ETFs tracked by EPFR Global
ballooned to a peak of almost $300 billion, tripling since 2008 and
up from next to nothing in 2004.
These cheaper and highly liquid vehicles, unlike mutual funds,
update prices through the day, adding another layer of price swings
to a volatile trading session.
ETFs accounted for almost half the $2.5 billion outflows from
emerging equities last week. So far this year, a net $4.12 billion
has flowed out, amounting to three quarters of the total $5.7
billion that has fled, the fund tracker said.
"Just as ETFs helped hot money go in in the boom years, so they're
helping it leave now," said Tom Elliott, investment strategist at De
Vere.
"You need to separate from your long-term investor who is putting
emerging markets into a pension fund, and the speculative investor
who is looking for more immediate returns and will almost certainly
use some measure of stop, such as NAV, both on the way up and on the
way down."
Another channel for contagion that has evolved in recent years is
emerging companies' debt.
Corporate bond sales have exploded since 2010, as companies shifted
their borrowing away from syndicated loan markets. While banks don't
face daily liquidity constraints, funds have to cover redemptions
daily as investors pull out. This means they may have to sell large
bond investments abruptly, increasing the risk of an intense market
correction.
DIFFERENTIATION
Innocent bystanders in emerging markets will continue to suffer as
investors, spooked by the Chinese economic slowdown, the looming
reduction in U.S. stimulus or by emerging markets' own problems — such as the current political turmoil in Ukraine — yank cash from
the sector.
"When the news flow comes through that China is a bit weaker than
you thought, you got a downgrade in Argentina and Venezuela, and the
rouble was in trouble, you had the Ukrainian situation...that just
spooked people so they have withdrawn liquidity and are sitting back
and seeing where it falls," said Gary Dugan, Asia & Middle East CIO
at Coutts.
Some markets may benefit eventually, but not for the time being, say
investors. While asset prices, from stocks to currencies are
starting to look cheap and many economies are fundamentally sound,
dipping in a toe now is highly risky.
Policymakers are keen to proclaim the merits of their own countries,
with the Mexican and Colombian finance ministers expressing
confidence in investors' ability to differentiate between good and
bad emerging markets.
That could take a while, however.
"We are in full-blown financial contagion mode. There is no point
spending too much time trying to pick and choose when faced with a
severe market crisis like the one we are witnessing," said Benoit
Anne, head of emerging markets strategy at Societe Generale.
He added: "Right now, sell everything."
(Additional reporting by Vidya
Ranganathan in Singapore and Simon Jessop in London; editing by
David Stamp)
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