Fragile 5: Will Rising Interest Rates Impact These Emerging Markets?

So far the markets seem to have taken the US Federal Reserve's (Fed) 'taper' of its quantitative easing program in stride. Markets in developed countries are hitting new highs. Growth in the US looks strong. Europe seems to have recovered. The Japanese money tsunami appears to have done some good. But there might be a fly in the ointment. The emerging markets, which for the past five years did so much to pull the world back from the brink, are beginning weaken. China is experiencing uncomfortable tremors in its financial system an omen of something very serious. The most obvious problems are in a group of countries called 'Fragile Five' countries; they include Turkey, South Africa, India, Brazil, and Indonesia.

This week the ten year US treasury bonds hit 3% for the first time in over two years. The end of one credit cycle and the beginning of rising interest rates will be bring many changes. For emerging markets and especially the Fragile Five, one of the main impacts will be with their currencies.

While the Indian Rupee has strengthen a bit from its September bottom, the Brazilian Real has not. The Indonesian Rupiah and the South African Rand are declining while the Turkish Lira has hit a record low. The fall in currencies is especially a problem for the Fragile Five because one of the many things they have in common are deficits. The free money from the Fed allowed these countries and others to run deficits as their higher interest rates created a demand for their bonds and currencies. Now that has reversed. So far the decline has not been as dramatic as it was earlier in the year, but the trend is in motion.

Partially to protect their currencies Brazil, India and Indonesia have all raised interest rates. South Africa's are flat. In contrast, Turkey's interest rate has declined, one of the reasons for the Lira's tumble. (Although confusingly the central bank's has allowed interbank rates to rise.) Turkey's failure to raise interest rates illustrates the dilemma for these countries. Falling currencies resulting in rising inflation and then rising interest rates potentially means slower growth. Slower growth means a political impact.

The embattled Prime Minister, Recep Tayyip Erdogan, is in the middle of a corruption scandal, which has already resulted in the firing of more than half of his cabinet and may even reach his family. Erdogan has blamed others for his problems including foreigners, the media and even the central bank The result is that the central bank's recent decision to defend the currency with reserves, rather than via higher interest rates, may have been affected by Erdogan's accusations that the bank's decisions are the work of an ill-defined "interest rate lobby" that he says is trying to hold Turkey's growth back.

Turkey's is not alone. Political risk is another aspect that the Fragile Five have in common. All five countries will hold elections in 2014. In elections years the ruling parties are happy to spend their way to maintaining power. In Brazil the budget deficit is growing. To limit inflation the government has resorted to price controls on essentials such as fuel. Any unpopular but essential reform necessary to convince markets of the strength of the economy will likely be ignored until after the election. But with rising interest rates and falling currencies, markets will not be either sympathetic nor patient with the problems of entrench politicians.

It is not just the markets that are unlikely to be impressed. Credit rating agencies have at least four of the Fragile Five in their sights for a potential downgrade in 2014. High on the list is India. Standard & Poor's considers the chances for a credit rating down grade higher for India than Indonesia. For Brazil a credit downgrade in 2014 is a distinct possibility, while two agencies have given South Africa a negative outlook. Oddly only Turkey has escaped, so far.

Like their emerging market peers, the Fragile Five have grown rapidly over the past five years. Although they have all slowed since 2011, with the exception of South Africa, their growth rates are still far in excess of developed countries. But the years of easy money has had a cost. The amount of debt has increased substantially. In Brazil the credit to the private sector has doubled in the past five years to 50% of GDP. Like Brazil, Indonesia has issues with consumer credit; its nonmortgage consumer credit has tripled since 2009.

Companies in all of these countries have been able to borrow cheaply and many will not be able to pay the loans back. Nonperforming loans, especially state banks, have risen substantially, although many are not recognized. India's state banks have nonperforming assets estimated to be about 10% concentrated in infrastructure and construction companies. Last summer Moody's sharply downgraded the ratings of two Brazilian banks BNDES, the nation's main source of long-term lending, and Caixa Econômica Federal, the state-run mortgage lender. In Turkey the police reportedly found that the chief executive of state controlled Halkbank, Suleyman Aslan, had $4.5 million hidden in shoeboxes in his home. Mr. Aslan claimed the money was for charitable donations.

The Fragile Five have another problem not necessarily related to their economic situation. Their financial markets are relatively large compared to other emerging markets. So when US interest rates rise and investors move capital back to the US, they sell developing countries with large liquid markets where exiting without large losses is easier.

Financial headlines focus on the US, China, Japan and the EU. Smaller countries are not supposed to have much impact on the world economy. But the Fragile Five are not small. Together they make up 14% of the world's GDP, larger than France and China combined. The global impact of problems in these countries cannot be ignored and most likely cannot be avoided.

Source: Fragile 5: Will Rising Interest Rates Impact These Emerging Markets?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. (More...)

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