The global decline in crude oil prices is beginning to reveal consequences around the globe far beyond the Russian ruble’s historic collapse last week. The magnitude of cheaper oil is beginning to rock the world’s emerging markets in two very different ways depending on whether nations are commodity producers or commodity importers. The fact that the global economy is teetering on the verge of a widespread slowdown – or worse – could magnify the effect of the ruble’s collapse on emerging markets and the bonds they issue.
“This is a tough time right now. It might take the 'R' out of the BRICS,” said Stephen Guilfoyle, chief market economist at Sarge986.com.
Global crude oil prices have dropped almost half to $60.59 per barrel on Monday after peaking above $115 in June, which has played a major role in the selloff in emerging market economies that rely heavily on exporting oil. The crisis in Russia has also been a driver of the selloff in emerging market bonds. “I would say around 40 to 45 percent is Russia-driven because of investor mentality, because if one emerging market tanks, then all of them are going down,” said Aryam Vazquez, senior Latin America economist at Oxford Economics.
Emerging markets are already seeing spillover effects in commodity-centric countries such as Venezuela and Brazil. And now, experts are beginning to see contagion among commodity importers.
“The effects are very much concentrated in Russia and oil producers, but there does seem to be a spillover to emerging market economies,” said Neil Shearing, chief emerging markets economist at Capital Economics.
Ordinarily, manufacturing-heavy economies that import commodities, such as Thailand and Indonesia, benefit from lower commodity prices, but that’s not happening, leading experts to ponder whether the global economy is on the cusp of deflationary pressures. “This is showing you there are greater forces at work. The global economy is really walking a fine line between outright disinflation and deflation,” Karl Snyder, chief market strategist at Garden State Securities, said.
Disinflation, or slowing inflation, can be good for oil-consuming countries such as the U.S., because as prices drop for commodities, such as oil, it leads to dropping gasoline prices, which help put money back into consumers’ pockets. But deflation, or a general decline in prices, is dangerous because it creates a reduction in the supply of money or credit and can create less demand for big-ticket items from airplanes to washing machines, causing prices to fall. Lower demand in the global economy is threatening because it can lead to a global depression.
Many “fundamentally sound” countries, such as Mexico, South Korea, Israel and the Philippines, should be performing better, but they’re not, according to Vazquez.
“The fundamental driver as to why they’re not performing well is because you have a herd of investors rushing out of the emerging markets. It’s just one mad rush out of the door,” Vazquez said.
But larger vulnerabilities still lie in the weaker oil producers, such as Russia, Venezuela and parts of West Africa, according to Shearing. Economists, however, are still concerned about the financial vulnerabilities in countries that have seen rapid credit growth, particularly Brazil and Turkey. “At the moment our focus is very much on oil producers. That’s where the key risks lie,” Shearing said.
Growth in many Latin American economies remains weak, and external conditions have not helped, as the slowdown also has domestic roots, particularly in Brazil. The region should grow by just 0.9 percent in 2014 and by 1.4 percent in 2015, according to UBS. “Much of the bleeding in Brazil has been due to the decline of its local currency,” the real, said Vazquez.
Emerging markets that are producers of commodities like oil are going to continue to get hurt, especially Venezuela, where oil revenues account for about 95 percent of export earnings and the oil and gas sector is around 25 percent of gross domestic product, according to the Organization of the Petroleum Exporting Countries.
“The one that’s been hit the most is Venezuela because so much of their economy is dependent on exporting oil. That’s the principal driver, but there’s another factor as to a lot of uncertainty as to whether the administration is going to implement the necessary policy measures to really avoid a default,” Vazquez said.
Economists at UBS agree. “Venezuela is walking the thin line of default,” UBS economists said in a research note. “Whether the authorities can avoid it will depend on their willingness to devalue and cut public spending.”
West African countries will also be hurt, such as Nigeria, but the country “doesn’t carry the default risk that Venezuela does,” Vazquez said, as Nigeria’s risks are more geopolitical rather than the domestic political risks Venezuela is experiencing.
Asian Emerging Markets
Although Asia’s financial markets have not escaped the turmoil from Russia’s crisis, they have fared better than other emerging market regions because of three key factors, according to Capital Economics. First, the region has few direct links to the crisis in Russia. Second, Asia stands to benefit from falling oil prices and third, most countries have strong external positions.
“It’s certainly the case that you would expect more open economies, particularly in Asia, to benefit from the U.S recovery. It doesn’t seem to have quite filtered through, particularly in the case of Taiwan and [South] Korea,” Shearing said.
But that’s not quite happening yet, but there might be a few reasons for that, according to Shearing. “One reason might be that this U.S. recovery is less important than previous recoveries. The other point maybe that there are local factors holding back the recovery in each case, particularly in Korea as the levels of debt are quite high, which keeps domestic demand low,” Shearing said.
U.S. Flight to Safety
Following Russia’s ruble crisis, the flight to safety has really been to the U.S. Treasury bond market and the German Treasury bond market, where the yields there are dropping close to “all-time lows,” according to Charlie Bilello, director of research at Pension Partners LLC.
“The deflation story is not one that worries me too much right now on the emerging market side. There’s still healthy inflation in Mexico, Colombia and Turkey,” Vazquez said. “The concerns are more about what kind of monetary policy is going to emerge in 2015.”
But how the volatility in the emerging market bond market plays out in 2015 depends heavily on pending central bank policy, as there’s been a divergence in global monetary policy recently. Following the U.S. Federal Reserve wrapping up its quantitative easing program in October, the Bank of Japan has unleashed a massive round of monetary stimulus while the European Central Bank debates whether to pump more stimulus into its markets in early 2015. The Fed is on course to raise interest rates next year, while the BOJ and ECB in contrast push towards more QE.
But can the BOJ and the ECB’s quantitative easing measures be enough to offset the Fed’s stance? “I personally don’t think it can,” Vazquez said. “The type of QE that they’re unloading doesn’t really have the muscle to offset the Fed.”
“At the end of the day it’s the U.S. market that drives the boat across the global financial market,” Vazquez said. “So when the Fed starts removing liquidity next year, it has that much more of an impact than what the ECB and BOJ can do to step in to fill that void.”