Service on Finance and Development (Oct15/02)
12 October 2015
Third World Network
Investors concerned over growing vulnerabilities in EMEs
Published in SUNS #8109 dated 9 October 2015
Geneva, 8 Oct (Kanaga Raja) - In their re-assessment of the global
growth outlook, investors increasingly focused on growing vulnerabilities
in emerging market economies (EMEs), particularly China, the Bank
for International Settlements (BIS) has said.
In its latest Quarterly Review released recently, BIS said equity
markets in China plunged following a prolonged surge in stock prices
that had propelled many stock valuations to extreme levels, and this
had dented investor confidence and weighed on asset prices globally.
The Basel-based central bank for the world's central banks said that
global financial markets have suffered repeated blows over the past
few months, with a number of them due to events in China. On the heels
of the Greek crisis, markets were roiled following a sharp drop in
the Chinese equity market and a surprise change to the renminbi's
exchange rate arrangements.
Markets, particularly in Europe, hit turbulence early in the quarter
as negotiations about renewed funding for Greece dragged on. This
was behind much of the under-performance of European equities, which
caused the EURO STOXX index to fall by almost 11% between end-March
and early July.
According to BIS, the drawn-out negotiations between Greece and its
creditors through the first half of 2015 gradually undermined market
sentiment. As the situation reached crisis proportions, with the banking
system closed down and capital controls in place, two-year Greek sovereign
credit default swap (CDS) spreads peaked above 10,000 basis points
in early July, after voters rejected proposed reforms in a referendum.
"Financial markets beyond Greece were also affected. In bond
markets, there were clear signs of flight to safety: for example,
German and Swiss bond yields fell on days when Greek CDS widened the
most and recovered on days when spreads tightened considerably."
Although the ongoing Greek crisis weighed on investor sentiment, the
direct contagion to other periphery euro area sovereigns was limited
and short-lived, said BIS, adding that eventually, as it became likely
in early July that a new programme for Greece would be forthcoming,
markets quickly recovered and investors started to turn their gaze
China's situation, in particular, received increasing market attention
as the country's equities fell sharply in late June and early July.
Following a spectacular surge lasting over a year, the benchmark Shanghai
Shenzhen CSI 300 Index lost almost one third of its value between
12 June and 8 July. The adjustment was even more dramatic for the
Shenzhen Stock Exchange (SZSE) ChiNext small technology company index,
which plunged by 40% over the same period.
The preceding run-up in Chinese equity prices was driven by increased
trading activity and build-up of leverage, which accelerated as the
central bank eased monetary policy. Combined daily turnover averaged
CNY 1.8 trillion ($300 billion) in the month up to 12 June, around
six times the 2014 average and exceeding that of the US stock market.
This was fuelled by over 56 million new trading accounts opened predominantly
by retail investors in the first half of 2015. Broker-intermediated
margin trading reached CNY 2.2 trillion ($360 billion) in early June,
an almost sixfold increase from the year before, representing approximately
8% of tradable market capitalisation.
Increased leverage went hand in hand with rising valuations: the CSI
300 price/earnings ratio went up from 10 in mid-2014 to 21 in June
2015, while the P/E ratio on the ChiNext exchange peaked at 143. Turnover
and leverage then plunged, reflecting new regulatory curbs and the
rapid retreat of retail investors.
According to BIS, as concerns over Chinese equity market fundamentals
persisted and authorities began scaling down their market-supporting
measures, the volatility increasingly spilled over to other markets,
especially in Asia. On 27 July, when the CSI 300 Index fell by 8.5%
- its largest daily drop since 2007 - equity markets across Asia,
and some commodity prices, suffered outsize drops. "In late July
and early August, equity prices in China and elsewhere briefly stabilised.
This respite was short-lived."
Concerns about China's growth outlook took centre stage as the People's
Bank of China (PBoC) on 11 August announced major changes to its foreign
While the measures were officially described as a step towards a more
market-oriented foreign exchange mechanism for the renminbi, the resulting
depreciation was seen by some as a sign that Chinese growth was expected
to weaken further.
Currencies in the region and beyond depreciated sharply in response
to the weakening of the Chinese currency. As price drops in commodity
markets accelerated, investors grew increasingly concerned about growth
prospects for EMEs more broadly, and the impact on the global economy.
When Chinese equity prices began to fall sharply again in late August,
global equity indices plummeted, said BIS, noting that between 18
and 25 August, while Chinese equities slumped by another 21%, the
world's major equity indices dropped by around 10%.
The S&P 500 Index closed 4% down on 24 August alone (a day when
the CSI 300 Index fell by almost 9%), after a 6% slide during the
day, amid intra-day stock price drops of more than 20% for blue chips
such as GE and JPMorgan Chase.
Against this backdrop, said BIS, implied volatilities shot up: the
VIX index surged to 40, its highest level since 2011, while EME implied
equity volatility (VXEEM) rose the most on record.
"Rising volatility was not confined to equities: commodity, bond
and foreign exchange market volatility all spiked to levels much above
By the start of September, the global equity market sell-off brought
the Datastream world P/E ratio back down to just below its median
value since 1987. Global P/E ratios had breached this median value
in early 2015, after their upward trajectory since 2012.
BIS underlined that China's economic slowdown and the US dollar's
appreciation have confronted EMEs with a double challenge: growth
prospects have weakened, especially for commodity exporters, and the
burden of dollar-denominated debt has risen in local currency terms.
According to one indicator, China's private sector manufacturing activity
contracted at its fastest pace in six years in August, while the purchasing
managers' index (PMI) in Brazil, Russia and Turkey remained at or
below 50 amid adverse country-specific developments.
In this environment, EME corporations, after ratcheting up their income-based
leverage to the highest levels in a decade, saw sharply rising credit
spreads. The depreciation against the US dollar of most EME currencies,
including those of both commodity producers and consumers, added to
the difficulty of servicing the dollar-denominated part of this debt.
After a brief but sizeable recovery in the second quarter of 2015,
the prices of most commodities continued their plunge, putting additional
pressure on commodity producers' exchange rates. Perceptions of weaker
global demand due to the fall in China's investment growth and, in
the case of oil, persistently high supply played a key role.
"Financial factors, too, may have contributed to the commodity
plunge. The fall in the dollar oil price can be partly explained by
the appreciation of the US dollar, which in the absence of such a
decline makes oil more expensive outside the United States."
Despite falling stock prices and rising borrowing costs, the US energy
sector stepped up its debt issuance, possibly in an effort to defend
market share. "High debt burdens may force these firms to keep
up their production simply to generate the cash flow they need to
service their debt, accentuating the downward pressure on oil prices."
Against this backdrop, said BIS, a number of emerging market economy
and commodity-exporting advanced economy central banks eased monetary
policy, including those of China, Hungary, India, Korea, Russia and
Thailand as well as Australia, Canada, New Zealand and Norway.
In Brazil, where a recession coincided with rising inflation and political
tensions, the central bank increased its key policy rate from 12.75%
in early March to 14.25%, citing above-target inflation as its primary
concern, but signalled a pause in further tightening.
As emerging market currencies sagged against the dollar, the PBoC
on 11 August announced major changes to its foreign exchange policy.
The renminbi would continue to trade against the US dollar in a plus-minus
2% daily band, but the central parity around which the band is set
would be determined by the previous day's closing market rate rather
than a preset target rate. This more market-oriented mechanism is
a step towards fulfilling the criteria for the renminbi's inclusion
in the IMF's SDR basket ahead of its review in late 2015.
This change led to further ructions in the foreign exchange markets.
The renminbi slipped by 2.8% against the US dollar in the two days
after the surprise announcement, before stabilising when the PBoC
intervened to support the currency.
Emerging Asia currencies reacted strongly, with the Malaysian ringgit
depreciating by more than 6% since the announcement, said BIS.
DIVERGING MONETARY POLICIES
BIS said that diverging monetary policies have continued to be an
important driver for markets over the past few months. With policy
rates close to zero, the Bank of Japan and the ECB continued their
respective asset purchase programmes, seeking to stimulate economic
activity and lift inflation closer to target.
At the same time, the US Federal Reserve and the Bank of England continued
to prepare market participants for an eventual increase in their policy
In particular, the Federal Reserve's efforts in this direction have
been ongoing for some time, thus keeping US forward interest rates
persistently above those in the euro area and elsewhere. But macroeconomic
upsets and bouts of market turbulence have prompted investors to scale
back their expectations for near-term rate hikes.
For example, whereas prices of federal funds futures contracts at
the beginning of 2015 implied an 80% probability that the target rate
would have been raised by September, and a 90% probability that it
would have happened by December, these probabilities had fallen to
around 32% and 58%, respectively, by 2 September.
These estimated probabilities dropped sharply twice during the quarter.
On 8 July, they fell to 21% and 54%, respectively, shortly after the
Greek referendum and on a day when the Shanghai equity index plummeted
by 6%. After recovering in subsequent weeks, they again slid in late
August following the extreme turbulence in global equity markets.
According to BIS, although the timing of the Federal Reserve's first
move has become more uncertain, interest rate differentials between
the United States and many other countries have remained wide, with
important consequences for foreign exchange markets.
In particular, except for a brief hiatus in the second quarter of
2015, the US dollar has been on an appreciating trend since mid-2014.
The influence of interest rate differentials on the dollar was particularly
stark with regard to the euro: as the difference between US and core
euro area interest rates began to widen again in the third quarter
of 2015, the dollar resumed its strengthening path against the euro.
Towards the end of the period, as US short-term rates edged down,
the euro recovered somewhat.
Interest rate differentials also affected the behaviour of investors
and borrowers. With interest rates at or near record lows in the euro
area, fixed income investors increasingly turned to higher-yielding
For example, flows into European exchange-traded funds linked to US
bonds surged. In the first half of this year, such flows amounted
to $4.8 billion, as compared with $4.0 billion in the entire year
of 2014 and $3.4 billion in 2013.
For their part, firms in the United States increasingly issued euro-denominated
debt to benefit from the low borrowing costs. In the second quarter
of 2015, total gross issuance of euro-denominated debt by US non-
financial corporations amounted to 30 billion euros, surpassing even
the brisk issuance of the previous two quarters.
"With ongoing ECB asset purchases weighing on the yields of core
euro area government debt, yield-starved European investors have welcomed
the rising supply of corporate debt."
BIS said that long-term government bond yields in advanced economies
edged lower to levels not far from the troughs reached early in the
year, following sharp but brief increases in the second quarter.
The yield on 10-year German government bonds, which peaked at just
below 1% in early June 2015, had eased back to around 80 basis points
by the beginning of September. US 10-year Treasury yields similarly
eased from around 2.5% to 2.2% over the same period.
The persistence of very low bond yields largely reflected unusually
low term premia. The influence of low premia was particularly stark
for euro area bonds.
Since the culmination of the financial crisis, estimated term premia
on 10-year core euro area government bonds gradually fell from above
100 basis points to around zero at the beginning of 2014.
Since then, said BIS, a prolonged slide in premia pulled yields down
close to zero in the second quarter of 2015, before both premia and
yields recovered somewhat.
This large downward move in euro area term premia coincided with growing
expectations for, and ultimately the implementation of, the ECB extended
asset purchase programme.
The sharper drop in euro area term premia than in US premia explains
much of the widening gap between long- term bond yields in the two
economies. Implied forward interest rate curves also show that much
of the current low-yield environment is the result of very low real
forward interest rates.
Real forward rates rise only very slowly, entering positive territory
only at horizons three years ahead for the United States, and six
years ahead for the euro area.
Moreover, even at 10 years ahead, real forward rates reach levels
considerably below those seen prior to the financial crisis, accounting
for almost all of the similarly large gap between current and pre-crisis
nominal forward rates.
The behaviour of institutional investors may have played a role in
explaining such unusually low yields. For example, as yields have
come down, the duration of pension funds' and insurance companies'
liabilities have lengthened, forcing them to step up their hedging
BIS said: "This has increased demand for long-term swaps, adding
to the downward pressure on yields. Such self-reinforcing effects
are likely to have been amplified in an environment where central
banks continue to exert great demand for bonds, and where investors
have persistently sought higher returns in longer-dated bonds."