*Emerging Markets: Contagion from trouble in the eurozone has not been widespread. Will it remain like this?*<http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000276324.pdf>
July 29, 2011 *During the current episode of trouble in the eurozone, emerging markets have fared better than in the spring of 2010, which was in turn better than during the Lehman episode. Perhaps the eurozone crisis has not been deemed “systemic” so far, which would certainly change if Spain and/or Italy went the Greek way (not to mention in the case of a full-blown US crisis). Indeed, the correlation of EM and Spanish CDS spreads is much higher and spans many more countries than in a similar comparison with Greece. Looking at “fundamental” contagion factors, Central and South-Eastern European countries look most vulnerable to further deterioration in Greece, while some Latin American countries are very exposed to Spain via the bank channel.* [image: a]During the current episode of trouble in the eurozone, emerging markets have fared much better than in the spring of 2010, when the Greek crisis first erupted. In turn, contagion then was milder than at the time of the Lehman Brothers bankruptcy. This may of course have to do with the extent to which a crisis is “systemic”, but it may also have to do with the emerging markets’ resilience to the Great Recession, which has probably led many investors to re-examine the EM risk-reward equation, particularly in relation to the developed markets. To assess contagion, both “fundamental” and “market” factors are important. The fundamental factors are given by trade and financial relations with the affected country (say, Greece). The market factors capture how vulnerable a country is to an increase in global investors’ risk aversion (measured for example by the VIX index). Among other things, a country will be more vulnerable to market contagion if it has large external financing needs, if the participation of global investors in their local markets is sizeable and/or if the country’s financial instruments are actively traded in global markets. In the current stage of the eurozone crisis, the fundamental factors point mostly to contagion risks in Central and Eastern Europe, particularly the Balkan countries (and Cyprus, a more developed country). Besides sizeable trade links with Greece, Greek banks’ foreign claims (cross-border loans plus loans by local subsidiaries) on some of these countries are quite large. For example, they account for almost 30% of GDP in Bulgaria. [image: a]Regarding EM financial markets, contagion from Greece on the CDS space has been subdued. An analysis of co-movements between Greek and emerging markets’ CDS spreads shows a low, zero or even negative correlation. However, this correlation becomes positive and more significant if the comparison is made with Spanish (or Italian) CDS spreads. Admittedly, simple correlation is a crude measure and its actual size varies depending on the period considered. As the IMF points out in its recent euro area spillover report, “raw” correlations include both country-specific contagion (e.g. due to trade or banking ties) and the common market effect (generalised market nervousness). In any case, the important point here is that Spain and/or Italy are the countries to watch regarding potential contagion to emerging markets. The significant presence of Spanish banks in Latin America makes this region especially vulnerable (comparable to the Balkans for Greece). According to our calculations based on BIS data, Spanish banks’ foreign claims amount to 30% of GDP in Chile and 13% of GDP in Mexico. Despite low actual contagion, it is worth looking at potential EM vulnerability to global market shocks. Countries like Turkey, Ukraine, Poland, Romania, South Africa and Hungary have high external financing requirements (EFR, measured as the current account deficit plus the external debt maturing over the next 12 months). In all these cases, EFRs are higher than the stock of FX reserves, which would in principle indicate heightened vulnerability. However, in the case of CEE countries featuring an extensive foreign bank presence, a significant portion of external debt maturities are loans from parent banks to their subsidiaries, which only in a very severe crisis would fail to be rolled over. [image: a]As mentioned above, another potential contagion source is the holdings of domestic securities by foreign investors. These are sizeable in EM stock markets: foreign investors hold over 10% of the stock market capitalisation in around 20 emerging markets. That EM stock markets are very sensitive to global market sentiment is also evident in the very strong (opposite) movement of the MSCI-EM and the VIX index. With regard to domestic bonds, foreigners hold a significant portion of the total (18% and above) in Indonesia, Mexico, Poland, Hungary, Turkey and South Africa. In these cases, if foreign investors rushed for the exit, the bond price effect would be compounded by local currency weakness. Summing up, countries in Central and South-Eastern Europe appear the most vulnerable to the eurozone crisis, although other emerging markets – especially in Latin America – could be affected if the crisis engulfed Spain and/or Italy. This would clearly mark a new stage in the crisis, possibly reaching systemic levels à la Lehman. This contagion analysis can be applied to other sources of crisis, for example the looming fiscal crisis in the US. In this case, however, it would be necessary to add the impact of a potential USD crash on EM currencies, the reaction of commodity markets, and to take into account very disruptive financial market ripple effects. The overall impact on emerging markets would likely be severe and widespread, including Asia. -- Best Regards, Jay Shah, FRM *Expect the unexpected!!! * -- You received this message because you are subscribed to the Google Groups ""GLOBAL SPECULATORS"" group. To post to this group, send email to [email protected]. To unsubscribe from this group, send email to [email protected]. For more options, visit this group at http://groups.google.com/group/globalspeculators?hl=en.
