INVESTMENT FOCUS-Tightening already under way in Fed-hit emerging markets
LONDON, June 28 (Reuters) - A firmer dollar and rising U.S. yields are fuelling a steady increase in money market rates across emerging economies where many central banks could be forced to raise interest rates to stem an investor exodus.
For a sector whose high growth rates and burgeoning consumer demand were the prime draw for trillions of dollars in investment, this effective tightening in monetary conditions, months before the U.S. Federal Reserve even starts reducing its money-printing, could prove a huge blow.
The half-point rise since May in U.S. Treasury yields, the benchmark against which all other assets are measured, has set in motion a process that Morgan Stanley analysts describe as a "malign rise in real interest rates" - an exogenous policy tightening dictated by the Fed.
Markets are "mimicking the classic effects of a tightening of EM monetary policy," Morgan Stanley told clients.
"(First), higher borrowing costs in U.S. dollar funding markets and (second and) more importantly, a tightening of domestic financial conditions that will dampen growth as well as possibly the support for asset prices," they added.
The impact of the Fed-led tightening stretches from sovereign dollar bonds where overall borrowing costs have risen around 150 basis points in the past month - to domestic debt where in some countries, yields have spiked as much as 250 bps.
The latter effectively reverses the fall in borrowing costs that emerging markets experienced since early 2010.
"A lot of bond issuers have not fully woken up to the fact that issuance at higher yields will significantly change their debt sustainability picture," said David Hauner, head of EEMEA fixed income strategy at BofA-Merrill Lynch Global Research.
The other big fallout is being felt on local money markets, used by banks to borrow and lend in the short-term, as highlighted by the recent cash crunch in China that drove overnight deposit rates to record highs.
While the Shanghai crunch was partly engineered by authorities to curb banks' excesses, monetary conditions are clearly tightening elsewhere too, exacerbated by hefty foreign capital outflows from domestic stock and bond markets.
GRAPHIC on EM money markets http://link.reuters.com/meb39t
Data from fund tracker EPFR Global shows record outflows in June from emerging equity funds while debt funds' losses in the past week hit all-time highs.
That capital exodus has led to a sudden and sharp squeeze in short-term cash availability, driving overnight interest rates to multi-month and even multi-year highs in many countries.
Analysts at JPMorgan note the impact of this retrenchment on money markets, as reflected on their ELMI Plus index, a weighted average of money market rates across emerging markets. Its yield leapt to a four-year high of 5.33 percent last week.
The ELMI Plus average yield is at an elevated 4.16 percent, versus 2.7 percent in early May, according to Andrew Szmulewicz, executive director in JPMorgan's global research team.
Higher interbank rates are significant because they make banks reluctant to lend, and the rise in the cost of cash on these markets ultimately raises borrowing costs for consumers.
In some markets such as Indonesia and Turkey some of the liquidity squeeze is self-created - in Turkey for instance the central bank has tried to support the weakening lira by squeezing liquidity on interbank markets.
"To the extent that the retrenchment of foreign creditors becomes more persistent, emerging credit creation could slow sharply, hurting economic growth," analysts at JPMorgan said.
"It is also problematic that this credit shock is hitting EM at a time when growth is already weakened."
FED TIGHTENING TO EM TIGHTENING
Meanwhile, the spike in Fed-induced market volatility may force many countries to jack up interest rates, especially those which rely on foreign fund flows to plug financing gaps. Indonesia's hike this month may be the first of many to come.
Countries with big foreign financing needs such as Turkey, South Africa and India are acutely vulnerable to the risk of a sudden stop in investment flows and will be forced to counter any such threat with actual policy tightening
Swaps markets are betting for instance that rates will rise in Turkey and Brazil by almost 200 bps over the coming year and by almost 100 bps in South Africa. Markets expect rate hikes even in relatively robust South Korea.
"Money market rates are going to go up where markets are pricing rises in interest rates," said Hauner of BofA/ML.
"In countries such as Turkey that have been running a relatively loose policy, unless the market situation improves a lot, you will see an increase in interest rates because (interest rates are) providing no support to the currency."
Of course if the Fed raises interest rates, other markets will have to follow suit. The World Bank this month predicted interest rates would rise more in emerging economies than in their advanced counterparts.
It expects the developing world to grow 5.1 percent this year from the 5.5 percent predicted in January. Once the Fed finally raises rates, it said, output could drop 7-12 percent.
(Graphic by Joel Dimmock Editing by Jeremy Gaunt)