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Increase in Emerging Market Risk Following Turkish Lira, Chinese Yuan Deterioration

September 29, 2018

The trade wars have been progressively escalating between the US and China for the past five months. Yet, the implication that trade war represents to the rest of the world economy has been toned down by the global investors. The weakening of the Turkish Lira after the implementation of US tariffs spread to the euro on August 10th, is worrying market participants globally. The exposure of European banks to the Turkish economy surfaced the concern of contagion. In total, Europe is owed $194 billion from Turkey. And, while action from Turkish regulators and an investment assurance from Qatar have offered some hope of stability, the damage to investor satisfaction may already be done.

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The Battle of Higher Returns and Higher Risk

Emerging markets, in part due to their higher interest rates, offer investors the prospect of high returns should they be willing to accept elevated risks. The opportunity for higher growth is quite an attractive prospect for many investors as well as banks, especially considering the stable economic conditions the world has experienced in recent years. The economic climate encouraged many European banks to confidently increase their exposure to emerging markets like Turkey and China.

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Contrary to the ‘developing’ world, many of the developed economies still maintain record low interest rates, attempting to maintain their current levels of economic growth. However, with a benchmark like the US moving to normalize its benchmark rates and other major leaders on the verge of following suit, emerging markets may steadily lose attractiveness as rate disparity decrease while the skew in risk grows.

Emerging Markets Suffer Losses despite the Promise of High Return

With a few minor exceptions, emerging market currencies have been pummelled during the last twelve months, with the most recent Lira developments aggravating losses. The South African Rand for example has seen considerable weakness on the back of the Turkish currency’s drop, most likely due to the country’s similar size and profile, since the two countries do not have significant exposure to each other.

The longer time-frame also showcases when the Ruble’s losses started to accumulate. Due to tariffs and sanctions, the Russian Ruble felt serious pressure in the past 3 to 6 month range – though it has not seen the same scale of loss as Lira or arguably the Rand. The resilience of the Ruble is likely due to its large volume of energy exports, consistently providing the nation with a steady stream of income despite geopolitical concerns.

Yet the Ruble may fall under further pressure in the coming weeks after US Deputy Secretary of the Treasury Sigal Mandelker said the US “will not hesitate to bring economic pain to Russia if its conduct does not change.” Should the US impose further restrictions on Russia, the Ruble would undoubtedly feel significant pressure, adding to the broader turmoil in emerging markets.

The Chinese Yuan has similar slid in the past weeks as the United States presses on with import taxes targeting specifically China. Yet, like many emerging markets in Asia, the Yuan has suffered less than other geographical regions in just this past week due in part to markedly fewer contagion fears.

Developed markets have also lost ground to the dollar during this time. The Japanese Yen and Swiss Franc have performed admirably, due to their stability and relative safe-haven status. The two havens received a boost after the recent emerging market contagion fears, offering a rebound from some of their losses earlier in the year.

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If volatility persists or global capital markets outright decline, the stability factor will matter far more than a modest yield advantage. In that scenario, the Dollar may very well rise, but emerging markets would almost certainly face further capital outflows as investors look to protect their funds.

Sanchita Bhatia

PGD-FA(2018-19)

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