- Our base case scenario for Middle East events is still for a short-lived disruption to the global economy and financial markets (Wells Fargo – The Conflict with Iran: FAQ with the Team). But the downside scenario of a prolonged rise in geopolitical uncertainty and sustained markets volatility is increasingly more likely and needs to be evaluated. We assess this elevated geopolitical uncertainty shock scenario for emerging market economies and financial markets through a vulnerability lens.
- Most EMs have reduced vulnerabilities to a sudden stop in capital flows, especially the systemically important countries (e.g., China and India). However, in the event of a sudden stop, countries reliant on external financing with adverse sovereign debt profiles and inadequate FX reserves are most vulnerable. Those with elevated vulnerabilities can experience balance of payments crises, sharp economic slowdowns, or worse, sovereign default. Argentina and Turkey flag as most vulnerable, while Brazil and Mexico have only moderate vulnerability to a stop in capital flows.
- A sustained geopolitical shock can be another test to the resilience of EM FX. Over the last few days, EM FX has come under broad pressure, but market participants may show a renewed focus on fundamentals and valuations in a shock. Currencies associated with weak fundamentals and expensive valuations can see a sharp reversal (e.g., COP, MXN and ZAR). Countries associated with stronger FX fundamentals and more attractive valuations (e.g., TWD and KRW) can be more protected. At the same time, keep an eye on our framework’s “max selloff” levels for whether a currency has become too misaligned or is detached from underlying FX fundamentals. “Buying” or “hedging” opportunities may become available should those levels be breached.
- A combined FX and inflation shock via elevated oil prices limits EM central banks’ ability to cut policy rates further. Select central banks may still be able to cut as real interest rates are elevated and the shock hits less acutely (e.g., Brazil, albeit with less space). Others could see easing cycles end early as inflationary pressure builds from higher oil prices and FX pass-through, complicating already existing inflation pressures (e.g., Banxico). A few could restart tightening cycles even if growth prospects are damaged, as financial stability and containing inflation expectations becomes paramount (e.g., Reserve Bank of India).
- Should an affordability shock ensue from markets volatility and/or higher non-discretionary expenditures governments may be limited in their ability to respond via fiscal support. Public finance positions are already weak across EM, except for a select few. For certain governments, rising oil prices can generate increased revenues, boost growth prospects and offer new space to offset affordability issues. Administrations will need to weigh that dynamic against already wide fiscal deficits and large debt burdens (e.g., Colombia). But should governments without fiscal headroom ignore public finance limitations sovereign bond markets may turn volatile, and financing issues could follow.
