With prospects for real growth ahead, the Fragile Five might not be as brittle as you thought.
By Sameer Massis
The US central bank is in no rush to raise interest rates. Even though the Fed minutes released last June acknowledged America’s economy was strengthening, it suggested it was unlikely to raise interest rates before the second half of 2015. This came as a very dovish statement, which left interest rate hawks scratching their heads. Nevertheless, the Fed’s minutes maintained clarity in their schedule to end quantitative easing part 3. The Fed had trimmed the program by $10 billion at each meeting this year, and announced the final taper would be $15 billion in October. It was this tapering that Morgan Stanley feared would severely pressure currencies of certain emerging economies.
It was back in the summer of 2013 that Morgan Stanley first coined the term Fragile Five in reference to the South African rand, Brazilian real, Turkish lira, Indian rupee, and Indonesian rupiah. Despite the fact that some of these countries were darlings of international investors over the past decade, unlike developed markets or China, they all have one major weakness: very few investors are willing to hold their currencies in the long-term. If cracks in the economy are detected, investors are quick to dump their currencies, which would exacerbate their current account deficits. The economies of these countries remain vulnerable because of their reliance on foreign investments to fund current account deficits. Since their trade shortfalls consist of oil imports, the current high prices of oil, and general MENA instability would dent the economies of these five countries more than their counterpart developing countries.
Even though foreign investors are keen to fund growth in these countries, a reversal of loose monetary policy by the United States would end the era of cheap money. This would retract foreign capital from such markets to quality safe havens of developed markets. The World Bank even raised this concern as it pondered repercussions of tapering on the markets. It cautioned that a disorderly tapering might cause cash flow to developing nations decline by 80 percent for several months. In 2013, all five countries had their currencies fall against the dollar by significant amounts: South African rand fell 19 percent, Brazilian real fell 15 percent, Turkish lira crashed by 24 percent, Indian rupee fell 14 percent, and Indonesian rupiah fell 21 percent.
All “Fragile Five” countries have parliamentary or presidential elections this year, which adds further political risk to the mixture, as investors fret about issues in the MENA region, and expropriation risk in Latin America. Nevertheless, despite the additional notional risks, there were certainly gains realized in the “not-so” fragile countries in reality in 2014. Some countries found these political changes as an agent to bolster investor confidence through potentially driving the engines of reform. They also had to raise interest rates to draw investor’s cash. For instance, India lifted its rate to 8 percent, and Brazil hiked its rate to 11 percent. South African economy was discussed in Venture’s March issue, investment opportunities in Brazil, and Turkey were more recently discussed in Venture’s June and July’s issues respectively. This month we focus more on India and Indonesia to complete discussion of the “Fragile Five.”
India carries some significance: It’s the world’s second most populous country with over 1.2 billion people, and has a nominal GDP of $2 trillion, ranked tenth in the world. Even though considered an industrialized country, it continues to face challenges of poverty, inadequate healthcare, and widespread corruption and incompetence. This overshadowed the growing financial openness of India that Prime Minister Manmohan Singh engineered during the 1990s. Challenges of slowing growth and rising inflation continued to change the political tides towards the opposing BJP party, which culminated to a win in last May’s elections in India. The new prime minister, the more authoritarian Narendra Modi, had previously positioned his state of Gujarat as the “China of India,” and certainly plans to carry this momentum forward throughout India. Modi’s election win was the most decisive of the past three decades, and places him in a commanding position to enact much needed economic reforms.
The OECD’s “Economic Outlook for Southeast Asia, China, and India 2014” report reiterated the robustness of India’s growth in the medium-term, anchored as it is by a steady rise in domestic demand. India’s economy is forecasted to grow at a solid rate of 5.9 percent, albeit still under the regional Asian economies’ average of 6.9 percent.
Morgan Stanley currently estimates India’s stock market at its long-term trading P/E valuation of 14, whilst its P/B value is somewhat overvalued at 2.4. Nevertheless, the current political optimism for economic change buoyed the market to over 24 percent on a year-to-date basis. Time will only tell whether the economy will actually improve as the new government initiates and implements economic reforms.
In contrast with the seemingly fragile economic region, Indonesia remains in a better shape. Noteworthy is its narrowing current account deficit due to stronger exports on a backdrop of a slowing economy. Because of this, its currency had appreciated this year, and inflation has even slowed as food prices eased, and fuel subsidy cuts have abated in 2014. Bank Indonesia can even afford to begin lowering its policy interest rates soon, while its fiscal policy remains broadly expansionary, as it’s likely to expand the social safety net and invest in infrastructure. However, the outlook isn’t all rosy in Indonesia, as its rupiah remains vulnerable to international interest rate movements, especially as its external balance developments remain highly uncertain. In case of a sudden deterioration in its financial standing, it will need to respond with swift monetary and fiscal measures.
This year is also an election year for Indonesia, as last July it welcomed the prospect of reform-minded Jakarta Governor Joko “Jokowi” Widodo becoming the next president. This should provide a somewhat smooth transition from the outgoing president Susilo Bambang Yudhoyono who plans to gracefully retire. Jokowi, however, is more likely to break free of the current office model occupied by former generals, into one more professionally and economically minded. For a sign of things to come, look no further than what Jokowi accomplished as mayor of Solo, a crowded city in central Java, where street vendors and squatters blocked commerce. Jokowi managed to cut deals to move these squatters to homes, created job-training programs, and new public transit links. He even brought minority Christians and Chinese into his administration as a sign of diplomacy within the diverse Indonesian culture.
The latest OECD report forecasts Indonesia’s GDP growth to be the fastest within the ASEAN-6, with an average annual growth rate of 6 percent during between now and 2018. This is commendable, but the challenge remains to place efforts to reduce inequality and share the proceeds of economic success more equitably in the country. This can be done through structural reforms in policy areas of investment, infrastructure, and education as well as policies to promote innovation and entrepreneurship. In order to accomplish this effectively, Indonesia still needs to overcome internal barriers that stifle competition and inhibit foreign investments. Addressing these internal issues would not only allow the rise of a solid export market, but also the integration of Indonesia’s value chain within the global economy.
Similar to the Indian equity market, the Indonesian stock market is also in the “middle of the pack” in terms of its P/E valuation of 15, whilst its P/B value is overvalued at 3. Nevertheless, the Jakarta market rose 25 percent on a year-to-date basis. This reflects the expected growth opportunities in the 238 million populated archipelago nation comprised of 13,466 islands. Its national motto, “Unity in Diversity,” helps unify hundreds of distinctive native ethnic and linguistic groups. If its market volatility can be digested, then opportunities may abound.