Ukrainian asset prices are currently under pressure as
markets fret over its weak fundamentals of having twin deficits, limited cash/currency
exchange buffers, uncertainty on the political front around its relationship
with the European Union and Russia, and ability (or otherwise) to finance
itself in a new world of tapering. After Moody’s decision to cut Ukraine’s
sovereign LT FC rating to Caa1 last week, the assumption is that further rating
downgrades by Fitch and S&P will follow, creating something of a vicious
cycle.
The above raises an interesting question as to whether a
deteriorating situation in Ukraine will create contagion pressures elsewhere in
emerging markets. Note that we expressed a relatively upbeat emerging markets big
picture view in our piece “Time
to dip your feet backing EM” published on Sept. 5, and therein we
highlighted that one encouraging factor throughout the EM sell-off since May is
that while asset prices (currency exchange, rates, credit and equity) have sold
off, and the media has been full of stories over the problems in EM, no
individual emerging market has “fallen off the cliff” yet into a full blown
currency crisis, or credit event. This has suggested a stronger underlying
story still in emerging markets than the media headlines suggest.
But if Ukraine is the first emerging market domino to fall,
how far reaching would the consequences be, and which dominoes could perhaps
fall next, if any?
First, in a scenario where Ukraine falls into an exchange
rate/balance of payments crisis, raising concerns also over credit risk, the
knee-jerk reaction will be to focus on countries with similar large budget or
external financing requirements. In this “contagion” category it would likely
be the usual suspects, i.e. Serbia (twin deficits), Hungary (likely large
external issuance needs given the government’s on-going plan to buy back
utilities companies), India (twin deficits), Indonesia (emerging twin
deficits), Turkey (large current account deficit and large external financing
requirement, with limited foreign currency exchange reserve cover), South
Africa (new found twin deficits). Perhaps with the exception of Serbia,
pressures in these economies are likely to be felt in foreign currency exchange/currency
space, initially, while we feel credit risk (at least in sovereign space) is
relatively limited. Second, no country appears particularly exposed through the
trading channel to Ukraine, e.g. through a scenario where a devaluation, credit
event with likely systemic implications for the banking sector, also impacts
negatively on the economy/trade in the short term. Investors might, however,
make a knee-jerk reaction to sell credits in the region, i.e. the CIS,
particularly.
Hence we could see selling pressure on the likes of Armenia,
Belarus, Georgia, and perhaps even Russia. In the case of Armenia and Georgia we
think these sales would hardly be justified as these sovereigns have limited
financing needs – Armenia has assured its sovereign financing for the year
ahead through its recent $700 million “Kardashian” bond issue. Neither Armenia
nor Georgia has particularly developed domestic capital markets through which
selling pressure could be felt, and their balance of payments appear relatively
assured for the time-being, i.e. underpinned by foreign direct investment or
longer term official/market financing.
Hence arguably softness in asset prices in Armenia and
Georgia might actually provide buying opportunities. Contagion to Russia from
Ukraine is likely to be relatively muted on the sovereign level, but perhaps due
diligence needs to be undertaken in corporate space to identify particular
corporations or banks with exposure in Ukraine. Belarus seems in many cases
similar to Ukraine in having weak underlying fundamentals, a wide current
account deficit and limited foreign currency exchange reserve cover. More
recently, its key relationship with Russia has come under strain over the
battle over the global potash market. Belarus also appears similarly vulnerable
through the exchange rate route and credit is also likely to be dragged weaker
in the process. That said, Belarus has a particular relationship with Moscow which
has seen Moscow step into the void to bail-out the Alexander Lukashenko regime
– e.g. in 2011. Key herein is Russia’s known desire still to accumulate assets
in Belarus, particularly in the potash sector, but also energy and
telecommunications. Our sense still is that ultimately another bail-out will
follow, but that negotiations could drag on as the two sides squabble over the
price of assets. This could still drag Belarus asset prices lower, and
especially in a scenario where Ukraine is under selling pressure.
Third, a further key risk could be forced selling by
investors with positions in Ukraine, and with significant portfolios elsewhere
in the region. We are sensitive to negative fund flows especially from retail
investors over the last few months. Ukraine’s higher yielding status has seen
similar concentrated positions accumulated also in Serbia and Hungary, leaving
these two credits vulnerable herein.
Timothy Ash is head of emerging markets research at
Standard Bank in London, United Kingdom.
