EMs could see policy reversal, market re-rating in Q4 2013

Financial conditions in Asia tightened considerably during the third quarter, as foreign liquidity inflows have reversed. Rather than offsetting this tightness in foreign liquidity, policy makers in India, Indonesia and Turkey are compounding the deterioration by tightening domestic liquidity conditions as well.

There is a clear risk that these policies will end up sacrificing growth to support exchange rates. While the policies are likely to be belatedly reversed, acting as a potential catalyst for a turnaround in the outlook for emerging markets, the change may come too late for investors.

Policy makers' decisions to tighten domestic liquidity via measures such as raising the cost of borrowing from the central bank (in India and Turkey) and increasing base rates (in Indonesia) are rooted in fears over inflation and the funding of current account deficits. Standard Chartered's 2013 current account deficits forecasts for Turkey, India and Indonesia are -8 per cent, -4 per cent and -2 per cent, respectively, and we forecast inflation of eight per cent, five per cent and seven per cent. In all three of these economies, raising the cost of funding is designed to attract foreign capital to fund the current account deficit and shore up the currency to limit imported inflation.

The slowdown in foreign liquidity inflows, as reflected in slower and in some cases contracting foreign exchange reserves, has weighed on domestic money creation and liquidity in emerging markets. By-products of this slowdown include depreciation pressure on exchange rates and anxiety over the funding of current account deficits.

As current policies are failing to support exchange rates and risk slowing economic growth, we believe policy makers will have to change course and reverse current policies. Such a policy reversal could come in the fourth quarter of 2013 and could trigger the start of an eventual re-rating of emerging market (EM) equity markets as investors gain confidence that policy makers are taking action to address the tightness in financial conditions.

We think policy makers are likely to eventually capitulate and dispense with current short-term policies to support their exchange rates. Once this capitulation is combined with supply-side measures, we would argue that over a six-month period, currencies could actually be stronger than they are today.

India stands out with regard to the capitulation of current short-term policies. We think elections, likely in 2014, combined with the current growth slowdown, could lead to a sooner-than-expected reversal of current policies by the Reserve Bank of India (RBI), which are accentuating the downside risks to growth.

Steep valuation discounts versus global developed markets, currently 30 per cent on a price earnings basis, could contribute to investors focusing on a marginal change for the better in the policy environment at a time when growth expectations and equity valuations are low by historical standards. We would highlight India as the market that could reverse course sooner rather than later, driven by pragmatic election considerations among policy makers. We are overweight on India and have a 12-month Sensex forecast of 22,000.

The author is managing director and chief equity strategist, wholesale banking research, Standard Chartered Bank