The picture for EM equities remains bleak. Policy stimulus in China has been ineffective in halting the nation’s growth slowdown, which continues to have a negative impact on commodity prices and EM terms of trade. Capital flows to the emerging world are likely to remain negative in the coming quarters or even years as the US Federal Reserve normalises monetary policy and the US dollar carry trade continues to unwind. EM growth momentum remains very negative, both from a macroeconomic and a corporate-earnings perspective. There is little reason to expect a recovery as long as growth data keep deteriorating.

China debt levels becoming less and less sustainableNo relief yet in sight for emerging equities

Total debt as % of GDP. Source: World Bank, PBoC, Oxford Economics

China’s market intervention may do more harm than good

EM equities underperformed heavily in the past weeks mainly as a result of the sharp correction of the Chinese A-share market. The direct effect of the sell-off is obvious, as Chinese stocks represent 25% of the MSCI EM index (the H-shares, A-shares are not included in the MSCI index). The indirect effect should not be underestimated too. With the Chinese authorities already struggling to stabilise economic growth, their heavy-handed attempts to prevent a complete stock market collapse have done little to improve confidence.

The dramatic market intervention has involved central bank buying of stocks, forced buying by pension funds and mutual funds, long-term commitments from public institutions not to sell stocks and the suspension of a large IPO programme. This may help reduce short-term downside risk for the A-share market, but implications for the medium to long term are less positive. The intervention confirms the government’s manipulative involvement in the Chinese equity market, and raises more questions about the free-market direction of overall Chinese government policies.

Financial system risk may be more serious than many think  

The apparent urgency with which Chinese authorities have tried to stop the correction suggests that the problems in the financial system may be more serious than many China watchers think. The government wants more equity market financing in order to reduce debt financing and bring down the skyrocketing debt-to-GDP ratio (see graph). The IPO suspension is already a big blow for these plans, and if weak market sentiment persists, equity market financing will languish and leverage in the system will continue to rise rapidly. Growing doubts about the sustainability of China’s growth model might lead to more capital outflows, which in turn could create more challenges for policy makers and eventually lead to a currency depreciation, something the country’s authorities have been fighting hard to avoid.

Stabilising growth becoming more difficult

Declining confidence in the direction and effectiveness of Chinese policies is a major problem for an economy that is already under pressure from weak global trade, capital outflows and growing signs of financial system stress. Deteriorating investor sentiment, or a further decline in confidence in policy makers, will make it even more difficult to stabilise economic growth. With China’s growth prospects continuously under pressure, a widespread recovery in emerging markets growth cannot be expected anytime soon.

The EM growth problem – with its origins in the China slowdown and the resulting correction in commodity prices, weak global trade and the endogenous obstacles to growth such as interventionist economic policies, eroded competitiveness and the required deleveraging after years of excessive credit growth – has been the main reason behind the clear underperformance of not only EM equities but also EM currencies relative to the other EM asset categories in the past years.

Carry trade remains attractive in EM for now

EM hard-currency debt, both sovereign and corporate, as well as EM local-currency (longer maturity) debt, have held up quite well so far. Investment flows into these categories have declined over the past years, but have not turned as negative as EM equity flows have. This can be explained by the still-attractive carry in the high-yielding emerging markets. Despite the growing worries about Fed policy tightening, US interest rates are still very low. EM rates are on average above 6% and the hard-currency spreads are apparently still attractive enough to prevent large selling.

Turkey is a good example of the low impact that Fed worries have had on high-yielding emerging markets so far. The large external financing needs of the country and its banking system are well-known. National politics have become messy and uncertainty about a new government is high. Nevertheless, capital flows to Turkey have held up remarkably well in the past years. Since the 2008 fall of Lehman Brothers, Turkey has not had a single quarter of capital outflows, not even in the second and third quarters of 2013, when the  “taper tantrum” coincided with the Gezi Park protests in Istanbul that spread across the country.

Foreign exchange reserves likely to keep shrinking

The impact of the normalisation in US monetary policy on the high-yielding emerging markets has been limited so far. That does not mean, of course, that higher US interest rates will not affect these markets more at some point. Between 2001 and 2014, the emerging world accumulated almost USD 7 trillion worth of foreign exchange reserves. This was made possible by the strong EM export growth and high commodity prices, but also by the capital flows from the low-yielding developed world.

With EM export growth now at low-single-digit levels at best, commodity prices are likely to keep feeling the pressure of lower Chinese fixed investment growth, and with US interest rates gradually normalising, total foreign exchange reserves in EM should continue to shrink. More repatriation of US capital and capital flight from the struggling emerging world to the US dollar should be expected in the coming years.

Higher US rates, EM risk could trigger more outflows

Higher US interest rates and the perception of rising EM risk –  probably due to a credit event in one of the emerging economies where leverage growth has been the highest – are the most likely triggers of sharper capital outflows. In our view, the main reason why EMD has held up well in recent quarters, is that US rates have not risen enough and that EM systemic problems have not emerged yet. In other words, risk/reward for EMD is still fair.