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Emerging-Market Currencies: Why Contagion Is a False Diagnosis

10/10/2018

Over the past several months, commentators and investors have repeatedly expressed concerns that a currency crisis in one or two emerging-market (EM) economies would more broadly infect other EM economies. These worries have roots in the “Asian flu” of 1997 and the Russian default crisis of 1998, where an initial debt crisis revealed similar structural weaknesses across other EM economies, causing a chain of market collapses seemingly leading from a “patient zero” country to its contaminated cohorts. 


While EM countries have reformed themselves dramatically since the late ’90s, diversifying their economies and solidifying their balance sheets, investor sentiment hasn’t evolved. People who should know better still reflexively cry contagion whenever any single emerging market is afflicted by a currency crisis, despite the lack of such a chain-linking episode in the past 20 years. We saw this dynamic play out earlier this year with the events in Turkey and Argentina. Both were eyed as the start of a contagion despite a shocking lack of commonality between these two countries, let alone among other countries experiencing negative currency returns.


So does that mean the only thing we have to fear is fear of EM contagion itself? To help answer this question, let’s first take a quick look at some facts surrounding the Turkey and Argentina crises.


Turkey and Argentina

These two economies were the focus of much consternation throughout Q2 and Q3 as the Turkish lira and the Argentine peso plummeted, decimating the value of equity and bond investments when viewed in US dollar terms. As investor losses mounted, commentators used charts like the one below to sound the alarm that the risk of contagion was high in the emerging markets.


Year-to-date currency returns vs. US dollar as of 9/11/2018


Contagion Chart 

Source: Bloomberg


But this was somewhat questionable from the start. The gap between the returns of the first four currencies and the bottom two is pretty dramatic, hardly supporting the notion that all six currencies were distressed. That said, both Argentina and Turkey were experiencing a classic crisis of confidence among investors regarding their currency losses.


Yet in reality there was very little connecting these two countries’ circumstances. Turkey had an autocratic president who spurned basic facts of economic theory, consistently bullied his central bank not to raise rates, and spurned the involvement of the World Bank or the International Monetary Fund (IMF) in working out a solution. The seeds of Turkey’s currency crisis lay in a long-standing current account deficit, which had worried investors since the days of the Fragile Five.


Argentina’s situation was almost the exact opposite. Having recently reengaged with the global economic community, it had a president who was bringing into place market-friendly reforms and an independent central bank that consistently tried to put a floor under the peso by raising rates. What’s more, when its situation seemed intractable, it called in the IMF for assistance. The seeds of Argentina’s currency crisis lay in investor doubts that its market-friendly president could survive the political challenge of bringing about fiscal austerity.


Looking for emerging-market currency contagion...

After the sell-offs in the lira and the peso, investors went looking for contagion and found it in such countries as South Africa, India, Russia, and Brazil. Charts like the one above became commonplace in investor notes and the financial press.


But to state the obvious, this is a little ridiculous on several fronts—while Turkey and Argentina were experiencing potentially existential currency crises, the others were simply experiencing returns typical of countries encountering economic, political, or social headwinds. Furthermore, there was very little to connect the declines in these countries’ currencies. The below table lays out the disparate dynamics that account for the moderate drops in these currencies. Instead of noting these, many commentators stretched to find a causal link to support the notion that the events in Turkey and Argentina were a contagion that led to the declines in the other four countries.


Contagion Table

Source: Parametric


...In all the wrong places

Which leads us to the one thing that does link all these EM economies—the investor belief that a contagion is ready to break out anytime a single country experiences a steep decline in its currency. By acting as if this were true, investors can cause such a contagion to come into being despite a lack of economic commonality. 


It’s no accident that the most recent example of a wholesale sell-off of EM assets took place during 2013’s so-called taper tantrum, when all investors reacted to the US Federal Reserve’s tapering of its asset purchase program by selling out of EM assets because, as everyone “knew,” EM currencies do poorly in times of Fed tightening. However, when no such crisis occurred, we saw a sharp recovery later in the year, and the only contagion ended up being investors’ false sense of certainty and not the actual EM economies.


The bottom line

While the risk of EM contagion is present, it’s no longer particularly common. Still, the emerging markets are a volatile place, with the potential for steep losses from a currency crisis in any single country. And while Turkey may be a minuscule weight in the MSCI Emerging Markets Index, for example, what if the next currency crisis is in a country in which the index is overly concentrated, such as China, Korea, or Taiwan? Given the relative unpredictability and severe consequences of a currency crash, diversification at the country level is the best way to address this risk when investing in the emerging markets.


> Knowledge is contagious: Watch a replay of our October 11 Emerging Markets Update webinar for more on this and other EM topics.


Potential Parametric Solution

Our Emerging Markets Strategy is designed to provide all-cap exposure to countries with the potential to outperform the index, with less volatility. Our investment process is based on mathematical principles of diversification, compounded growth, and volatility capture.



Tim Atwill

Tim Atwill, PhD, CFA – Head of Investment Strategy

Mr. Atwill leads the Investment Strategy team at Parametric, which is responsible for all aspects of Parametric’s investment strategies. In addition, he holds investment responsibilities for Parametric’s emerging market and international equity strategies, as well as shared responsibility for the firm’s commodity strategy.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.

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