One of the unintended consequences of G-4 QE policies has been the development of EM macro imbalances. These imbalances have manifested themselves in rising current account deficits, rising inflation, robust credit growth and a rapid buildup of USD-denominated debt. During this cycle, we believe rising current account deficits and rising debt were the most significant factors to plague EM. We delve into the EM imbalances and conclude that there remains a need to de-lever further. This process could take several years. The catalyst to delever was rising U.S. interest rates ahead of the Fed tightening cycle and this trend is expected to accelerate into 2016. As EM continues to deleverage and correct these imbalances, EM currencies should depreciate versus the USD.
Emerging Markets Have Levered Up
EM debt to GDP has risen dramatically in the QE era to a new record high of 182%.1 We define deleveraging as a period when the debt to GDP ratio falls. In our analysis to determine whether EM has begun deleveraging, we looked at 22 major EM countries. We found that Argentina, Brazil, China, Colombia, Korea, Malaysia, Mexico and South Africa remain most vulnerable to deleveraging, since debt-to-GDP ratios were still rising in those nations and the current account deficits were either rising or the surpluses were shrinking rapidly. On the other hand, India, Peru, Philippines and Turkey were seeing deleveraging well underway. In addition, those nations were also seeing declines in current account deficits with the Philippines registering a large increase in its current account surplus.
Most countries in the first quadrant (upper right) of the chart were still seeing steady increases in debt-to-GDP ratios over the last few years – a clear sign the deleveraging process has not begun. However, we expect the start of the Fed tightening cycle and a gradual rising trend in U.S. interest rates will be the catalyst to the deleveraging cycle in those countries. The anticipated start to the deleveraging process for those currencies in the first quadrant is likely to make them most vulnerable to a selloff against the USD, while those currencies in the third quadrant (bottom left) will most likely outperform from a relative perspective.
According to Goldman Sachs research, the deleveraging cycle often lasts more than a few years – a view we share.2 We expect that, as the deleveraging process kicks off, credit growth will slow, and so may the economy. As a result of slowing growth, monetary policy is likely to remain supportive. This is the transmission mechanism that will feed through to a depreciating currency.
We expect the USD bull market will continue in 2016, benefiting from the divergence in G-4 monetary policies, with interest rate differentials a key driver. We anticipate Fed tightening to have a much bigger impact on driving the USD higher rather than depending on further ECB or BoJ easing. There are limits to any potential sustained rally in EUR and JPY as monetary policy is expected to stay very accommodative. However, any potential monetary easing, especially by the ECB, could send the exchange rate significantly lower. The one-off RMB devaluation and introduction of the basket suggests Chinese policy makers are open to a more market-oriented exchange rate, which will allow CNY to gradually depreciate versus the USD. Finally, EM deleveraging will get underway, especially among the most vulnerable credits. But as a result should keep those currencies under pressure against the USD.
1 Source: Bank for International Settlements (BIS) – total debt, including households and not financial corporation and public, as of March 31, 2015.
2 The EM Credit Crunch: Measuring the Gap Before Crunch Time, June 25, 2015; and EM Difference: A Look Back and a Look Ahead, December 11, 2015.