As the source of recent fears lies in Europe, emerging markets have so far remained relatively quiet during the correction. Indeed, all markets depreciated, but less than in Europe. This was partly due to the fact that a large part of the unrealistic expectations about growth in the emerging world has already been adjusted over the past few years.
In addition, developments in the eurozone can create an advantage for emerging markets. In recent years, there has been much nervousness about the sustainability of capital flows to emerging markets in an environment of a decrease in monetary easing in de US. Due to the problems in Europe, the ECB is now forced into quantitative easing, and the Fed has to temporarily waive the first rate hikes. This is good news for emerging markets, which are highly dependent on foreign capital.
So while disappointing growth in Europe is an issue for those countries that export a lot to the old continent, it is helpful for the emerging countries that need foreign capital to fund credit growth and current account deficits. Lower rates in Europe and the US will clearly help to relieve pressure in many parts of the emerging world. All in all, this should have a positive effect in the near future. Strong inflows into EM bonds should result in currency appreciation and recovering equity markets.
However, there is a huge problem that continues to justify great caution towards emerging markets: China. The main driver of growth in the emerging world is faltering. Risks are increasing. The housing market went into free-fall and has placed a great deal of pressure on economic growth and the financial system. Meanwhile, China is facing capital outflows since the beginning of this year. This is a new challenge for policy makers and it should encourage investors to be more careful.
In the current jittery climate on financial markets, the focus could shift from Europe to China. If that happens, emerging markets are vulnerable. We have seen this to be true many times in recent years, after reports of declining growth or banking stress in China.