COVID | Emerging Markets | Fiscal Policy | Monetary Policy & Inflation | Rates
The ‘Fragile-5’ – Brazil, India, Indonesia, South Africa and Turkey – first came to attention as a relevant subset of emerging market (EM) economies during the taper tantrum in 2013. They can be thought of as a systemically important group of EM borrowers whose performance is a good bellwether for the asset class as a whole. They account for about ¼ of the world’s population. A key aspect of the Fragile-5 is that both local fundamentals and global conditions drive their economic and financial performance. Externally, they are open to a broad range of influences in terms of geography and sectors.
As a health crisis, COVID-19 (C-19) has affected the Fragile-5 in quite different ways (Chart 1). Indonesia has been part of a group of smaller Asian countries that have been able to limit infection rates, although these rates have begun to edge up more recently. Turkey was able to contain the early bulge in its infection rate. In contrast, Brazil, India and South Africa are experiencing more persistent problems. Weakness in healthcare sectors in all these economies is a problem adding to the economic damage from C-19.
Early in the C-19 recession, the Fragile-5 suffered a major negative asset price shock, in line with the deterioration in risk asset prices everywhere. More recently, these markets have rallied in line with global asset price buoyancy. I think Indonesia is best placed to avoid long-term damage from C-19. There are growing risks to the other four countries, however, especially from rising fiscal deficits (and public debt) and the growing risk of debt monetization. In my view, current asset prices (low or negative real rates) offer very little margin for safety against these risks.
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- The Fragile-5 recovered quickly from the capital flow shock in March, and rates have fallen
- The yield decline reflects a steep markdown in market estimates of nominal growth
- These steep declines should be evident in the GDP data in coming months
- The downside is that these growth losses have worsened the fiscal and public debt outlook
The ‘Fragile-5’ – Brazil, India, Indonesia, South Africa and Turkey – first came to attention as a relevant subset of emerging market (EM) economies during the taper tantrum in 2013. They can be thought of as a systemically important group of EM borrowers whose performance is a good bellwether for the asset class as a whole. They account for about ¼ of the world’s population. A key aspect of the Fragile-5 is that both local fundamentals and global conditions drive their economic and financial performance. Externally, they are open to a broad range of influences in terms of geography and sectors.
As a health crisis, COVID-19 (C-19) has affected the Fragile-5 in quite different ways (Chart 1). Indonesia has been part of a group of smaller Asian countries that have been able to limit infection rates, although these rates have begun to edge up more recently. Turkey was able to contain the early bulge in its infection rate. In contrast, Brazil, India and South Africa are experiencing more persistent problems. Weakness in healthcare sectors in all these economies is a problem adding to the economic damage from C-19.
Early in the C-19 recession, the Fragile-5 suffered a major negative asset price shock, in line with the deterioration in risk asset prices everywhere. More recently, these markets have rallied in line with global asset price buoyancy. I think Indonesia is best placed to avoid long-term damage from C-19. There are growing risks to the other four countries, however, especially from rising fiscal deficits (and public debt) and the growing risk of debt monetization. In my view, current asset prices (low or negative real rates) offer very little margin for safety against these risks.
A Different Kind of External Shock
A key reason why the Fragile-5 were fragile in 2013 was that they were running relatively large current account deficits at a time when capital flows were interrupted (Chart 2). These external deficits had been significantly reduced by 2019. Turkey – arguably the most fragile of the 5 – had moved into surplus.
The global credit market panic associated with the onset of the global C-19 recession in March led to a short but sharp outflow of capital from the Fragile-5, as reflected in a significant, but hardly catastrophic, foreign exchange reserve loss (Chart 3). As in 2013, flexible exchange rates were an important and helpful outlet for some of these pressures (Chart 4). The corner in financial conditions was turned when the Fed (and other DM central banks) eased significantly in the second half of March.
The most important way in which the 2020 crisis differs from the 2013 shock, however, is that lower rather than higher global bond yields have set a dramatically different backdrop for monetary policy in the Fragile-5. In 2013, outright Fed hikes were more than three years away, and other DM countries ended up easing further (into negative territory). Steepening yield curves, weaker FX and lingering worries about FX pass-through pushed central banks in the Fragile-5 to hike policy rates (Chart 5). In the current episode, however, rates have been trimmed dramatically. Using current inflation rates as a deflator, Indonesia and South Africa have slightly positive real short-term policy rates, while they are close to flat in Brazil. They are significantly negative in India and Turkey.
Decomposing Recent Yield Declines
The C-19 crisis has delivered a dramatic decline in global bond yields. This has been true in both DM and EM markets. Since 1 January, 5yr US nominal yields have fallen by 141bp. Equivalent nominal yields have fallen by 61bp in Brazil, 153bp in India, 14bp in Indonesia, and 218bp in South Africa. The exception is Turkey, where 5yr yields have risen by 171bp.
We can decompose the change in yields reflecting real growth and inflation conditions from those reflecting credit risk using the credit default swap market (Chart 6).
CDS spreads for all of the Fragile-5 countries have risen since 1 January; most for Turkey and least for India. The difference between the change in nominal yields and sovereign credit risk can be explained as the market shift in expectations for growth and inflation. These have fallen most in South Africa and least for Turkey and Indonesia. For Turkey, persistently high inflation and inflation expectations have limited the nominal yield decline.
The Growth Damage From C-19
The near-term growth damage from C-19 has been substantial for the Fragile-5. It appears to have been most significant to date in Brazil, where Q1 GDP fell 6%q/q, saar (Table 1). Two of the Fragile-5 – India and Turkey – were among the small number of countries that posted positive growth in Q1. For India, the relative importance of agriculture helped sustain positive growth (2.7%q/q, saar), albeit well down on the 5% average of 2018-19.
The growth picture worsened dramatically across the board in March and April. Accurate short-term hard data indicators are limited for the Fragile-5. Manufacturing PMIs slumped through April although have since uniformly improved. Brazil’s monthly GDP proxy in April-May was down 47.5%, saar, over Q1. Assuming a 5%m/m, sa, rise in June would leave the proxy down about 37%q/q, saar, in Q2 versus Q1. Similarly, Turkish IP in April-May was 78%, saar, below Q1. Assuming a 6%m/m, sa, rise in June, Q2 IP would be down about 60%q/q, saar, in Q2 versus Q1. I think that would map into a 40%q/q, saar, GDP decline. India has clearly suffered a major economic dislocation in Q2. The service-sector PMI in April fell to just 5.4, which (as far as I am aware) is the lowest PMI reading ever recorded. Indonesia has been least affected.
It is hard to know how confidently to project a rebound in 20H2. Both Turkey and Indonesia have made progress in controlling the virus so should be able to lift restrictions. Politicians in Brazil, India and South Africa are struggling with rising or persistent infection rates, raising risks to the projected rebound.
For 2020 as a whole, I project Indonesian GDP to be close to flat y/y; India to contract 2.2%y/y; South Africa and Turkey by 3.6%y/y; and Brazil by 6.4%y/y. While pretty grim, those forecasts are mostly more upbeat than the latest round from the IMF, which looks for India to contract by 4.5%y/y; Turkey by 5%y/y; South Africa by 8%y/y; and Brazil by 9.1%y/y. I surmise that my forecasts project a less bad Q2 and more of a normalization in 20H2 than those of the IMF.
Fragile-5 consumer price inflation has been mixed in recent months. Turkey stands out from the other four economies in sustaining inflation persistently above 10%oya (Chart 7). Inflation has moved up since October, even as the CBRT continued to ease, which helps explain the steepening of the local yield curve (in addition to rising country risk). Indian inflation has also risen, led by rising food prices, which have more recently fed through into core inflation. By contrast, headline inflation in Brazil, Indonesia and South Africa has fallen to new lows. The decline in Brazil is particularly noteworthy, given the historically tight long-run correlation between FX depreciation and inflation. In the past year, inflation has dipped from 4% to 2%, even as the BRL has depreciated by 36%.
The Fiscal Damage From C-19
The nominal growth damage from C-19 for the Fragile-5 will be considerable, with the likely exception of Indonesia. The upside of this weaker nominal growth is lower yields, although these may well now be close to their lows. The downside is what it means for the fiscal outlook and, therefore, credit risk.
Budget deficits have begun to deteriorate significantly in all countries (Chart 8). Turkey had the best starting position, South Africa the worst. India’s deterioration has also been quite rapid in recent months.
Falling interest rates are helpful in dampening the pace of fiscal deterioration. This is most evident in Brazil, where plunging rates and the relatively short duration of government debt mean that the nominal budget deficit (as % of GDP) in the year through May 2020 is still below the (recent) maximum seen in January 2016, even though the primary deficit hit a new high of 3.9% of GDP (Chart 9). The Bolsonaro government came to power with the promise that fiscal reforms would put the deficit on a sustainable downward trajectory, allowing real interest rates to decline and growth to pick up. Instead, growth has slumped, real interest rates have fallen, and public net debt/GDP has risen (the rise has been contained by the fact that the Brazilian public sector is a net FX creditor, so BRL depreciation tends to improve creditworthiness, all other things equal). Brazil, India, Indonesia and South Africa have relatively high debt/GDP ratios, which compound adverse debt dynamics quite quickly as nominal growth slows.
DM economies have been able to finance sharply wider budget deficits in 2020 via central bank purchases under QE programs. The C-19 crisis has seen the first forays by some EM central banks into the process of QE. Indonesia has adopted such a program, with the central bank buying about IDR 36.7 trillion in recent months (this is only 0.2% of GDP). Despite this ‘monetary’ financing, Indonesia’s monetary base had actually contracted in 2020-to-date (Chart 10). QE has led to a 39% rise in the US monetary base in 2020-to-date. This has been exceeded in Turkey, where the monetary base is up almost 80%, year-to-date. This does not augur well for inflation.
Phil Suttle is the founder and principal of Suttle Economics.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)