In any discussion of the economic and market outlook, even for Emerging Markets (EM), it is difficult to escape the pervasive influence of Brexit. The market reaction to the referendum vote suggested a degree of exposure for EM, as the MSCI EM index sold off along with global equity markets, falling around 3.5% on the day after the vote (though note that this was a smaller fall than the overall developed market or European indices). Currencies also weakened slightly, though these losses have begun to retrace. While it seems unlikely that EM economies will be anywhere near as badly impacted as the UK or even Europe, it is possible to envisage a few channels through which this could affect them.
Slower Growth Likely to Hit Trade
Perhaps the most direct macro impact to consider is trade. The UK is not hugely important for EM exports or imports. The biggest exposure is in central and eastern Europe (CEE), where 5.4% of exports go to the UK. So a scenario in which only UK growth and demand is hit would not be too problematic for EM. However, should Brexit deal a larger blow to broader European growth, the consequences for EM become more severe. CEE again is most exposed, but by far more: exports to the EU account for 66.3% of total exports from that region. Other parts of EM are less at risk, though a trade share of over 15% for the EU in both Asia and Latin America means a European slowdown would still meaningfully impact the fortunes of their exporters, if not their GDP.
Financial Linkages Also Pose a Risk
Geographical proximity to the Brexit epicentre is certainly beginning to seem a bit of a negative. Another problem for CEE is remittances; workers in the EU benefit, at present, from freedom of movement, and can work and live in any of the 28 member states. This has tended to see a flow of workers towards countries with higher wages, which allows them to send money home in the form of remittances. In the most extreme scenario where Britain leaves the EU and forces all EU migrants to leave, these remittances would vanish altogether. For now, they are at risk simply from lower growth in the UK. Slower growth in the rest of Europe also puts remittances from other countries at risk.
Eastern Europe Faces Additional Costs
Remittances, of course, are not the only capital flows rolling across borders. There must be a question over the stability of banking flows at a time of heightened uncertainty and potential recession. We saw during the global financial crisis and Eurozone debt crisis that followed that banks tend to retrench and consolidate at such times, and though this event is not on that scale in terms of its macroeconomic impact, there is still heightened uncertainty. Perhaps luckily for Emerging Markets, European banks have a relatively small presence in most of them. In terms of links to the UK, the most exposed would seem to be South Africa (21.6% of GDP), followed by Malaysia (12.7% of GDP), with claims in other EMs less than 5% of GDP. Looking at the EU excluding the UK, bank claims are most significant in the CEE countries, with claims over 70% of GDP in the Czech Republic, 44% in Poland and 39% in Hungary. The next largest exposure is in Turkey, where EU + UK claims amount to almost 12% of GDP. Latin America looks the least vulnerable region on this measure.
Minimal Inflationary Impact Expected
Emerging market growth, then, looks susceptible to a number of headwinds, though many look likely to be minor. As for inflation, for now the most obvious channel for the referendum vote to affect this would be via the currency channel. However, the currency response in EM was pretty small, and currencies have actually appreciated since. This implies a minimal inflationary impact. Of course, should Brexit result in a less favourable global trade environment, with tariffs and other protectionist measures, this would generate higher inflation, but this risk looks likely to be a long way off, if it happens at all (it is certainly not our base case). Another risk is that US data could come in stronger than expected, causing the market to start pricing in a rate hike for this year from the Federal Reserve. This would likely prompt dollar strength on a broad basis and so lead to currency weakness in EM. For now though, central banks should be able to cut rates to support growth where needed, without needing to worry unduly about inflation. Latin America (along with the other “Fragile Five countries”) have the most scope for this, much of Asia and EM Europe already have fairly low policy rates and so may need to turn to fiscal policy if the growth disturbance proves substantial. Overall, the drag on growth generated by the Brexit vote looks small and eminently manageable for Emerging Markets. There is a risk to growth for some economies, but the inflationary effects will be limited, allowing for supportive monetary and fiscal policy. The hardest hit economies are likely to be those in the CEEMEA grouping, thanks to a mix of trade and finance links. By contrast, Asia and especially Latin America look likely to be insulated, unless the vote sparks a more global crisis. We could very well be in the odd position, as EM investors, of treating Latin America as a safe haven. It’s a brave new world.
By Keith Wade, Chief Economist and Strategist
Provided by Schroder Investment Management (Singapore) Limited