Emerging Markets Insights

Original Article in MarketWatch

Matt Lasov, director of global research at Frontier Strategy Group, said the emerging markets’ performance in 2012 depends on their relationship to the euro zone.

“The euro zone is in a recession that is likely to get worse,” Lasov said. “We see a two in three chance that there is a breakup of the euro zone in 2012 — most likely Greece leaving.”

And “success for emerging markets will be determined by linkages to the euro zone,” he said.

“The clear outperformers in the short term are India, Indonesia, and Sub-Saharan Africa,” according to a research note from Frontier Strategy Group, referring to those markets as having “low linkage” to the euro zone. “These markets are characterized by rapidly growing domestic demand and diversifying economies that are creating middle class growth” and they have limited trade relationships with Europe.

The Middle East and Latin America are linked to Europe because of trading in commodities, the note said, referring to these markets as having “medium linkage” to the euro zone. “Reduced European demand for oil will impact state revenues, but most markets have more than enough reserves to weather a crisis.”

Russia, meanwhile, is “positioned to be the biggest underperformer,” the note said. “Oil exports to Europe are driving Russia GDP growth more than ever before,” and as oil prices fall below the $110 per barrel built into the Russian budget, “Russia will enter deficit.”

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What happened?

In 2008, banks stopped lending as they were forced to use capital to absorb losses from deteriorating investment portfolios. When lending dried up, business struggled, industrial production contracted, and jobs were lost.

Job loss drove the consumer into a deep recession. When the consumer lost its means to spend, banks found themselves in more trouble. Consumer-related debt securities holding everything from mortgages to credit cards to auto loans began to default, driving the deepest recession since the 1930s.

Governments stepped in as lenders of last resort to break the vicious cycle, but many governments were already overleveraged. As bad credit worked its way through the system, markets ultimately turned on indebted governments believing that governments would not be able to repay debt.

Enter the sovereign debt crisis

Markets revolted first against governments on the periphery of Europe because it was clear that those governments would run into solvency issues with no credible plans for economic growth. Ireland, Greece, and Portugal subsequently received bailouts but are still in trouble. Italy is on the brink and there is not bailout package on the table large enough to solve that crisis. Spain is next.

The crisis is not a Greek problem or an Italian problem. The crisis is a problem that impacts all of Europe as well as markets globally. Leading European banks based in Germany and France hold tremendous amounts of bad sovereign debt as well as derivatives on that debt. Much of this is not marked to market, so banks currently do not have to recognize losses. However, the event of a technical default will force banks to recognize losses that they are not capitalized to absorb.

A technical default is the worst-case scenario because it will disrupt the banking system, dragging Germany, France, and the broader global economy into recession. The only way to mitigate the impact of an EMU breakup is if the European Central Bank (ECB) preemptively recapitalizes banks, something Germany is opposed to because it fears inflation.

Regardless of the scenario that plays out, Europe is headed for recession and a breakup of the EMU. The only potential solution is a massive debt monetization program that would be led and funded by Germany through the ECB. However, this is becoming increasingly unlikely as policy heads the opposite way. On Monday, November 14^th, German Chancellor Merkel’s party voted to allow EMU members the right to remain in the EU free trade zone; even they left the monetary union. This is a critical first step in preparing the mechanisms necessary to support a breakup of the EMU.

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Berlusconi’s exit may mark the beginning of the breakup of the European Monetary Union (EMU), changing the business environment in Europe and markets globally. The problem in Italy lies in the country’s politics, not its economics; if the political class demonstrates they will do what is necessary, catastrophe can be averted. And over the past half century, Italy has often done the right thing (usually after exhausting all other options). The country’s politicians turned a ruined country into the world’s 8th largest economy, outwitted the most powerful and genuinely popular communist party in the western world, and entered the Euro, to name just a few accomplishments. Unfortunately, the challenge before them today is far greater and far less conducive to political machinations. The country has to decide whether it will be a competitive and dynamic economy or a larger version of Greece; the health of the world economy, and the future of the Euro, hang on the balance.

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German Chancellor Angela Merkel’s party voted today to provide a means for Euro-zone markets to voluntarily exit the Euro without losing access to the EU’s free trade zone. This move confirms that Germany is not willing to save the Euro in its current form and will begin to put in place additional mechanisms that will lead to exits from the Euro.

Retaining free trade with the rest of the continent is the key issue for markets like Greece, Italy, Portugal and Spain who would become more competitive overnight with a devalued currency and access to open borders.

If accepted by the broader EU, the move will make an exit easier for troubled markets, but it may also put undue pressure on the banking systems in Germany and France. Any exit would cause default, meaning that German and French banks have to absorb losses on bad debt and associated derivatives. A preemptive strategy to recapitalize banks will be required if Germany is to protect itself while paving the way for weaker markets to leave the Euro.

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“If Greek voters vote no, Greece will default and drop the Euro as its currency, switching to a “New Drachma.” Frontier Strategy Group sees a greater than 50% chance that Greece will leave the Euro.”

Markets reacted strongly this morning to Prime Minister George A. Papandreou’s announcement that Greece would hold a referendum on the EU plan for aid. The surprise announcement put the future of the Euro firmly in the hands of Greek voters who are likely to say no to aid for additional austerity. Share prices for European banks, who hold large amounts of Greek debt, plunged 8% and broad European markets were down 4% in early trading.

The Greek government used the referendum as a policy maneuver to buy time to negotiate more favorable terms with EU creditors. The play may backfire as Greek voters are tired of austerity, unemployment and ineffective government. If Greek voters vote no, Greece will default and drop the Euro as its currency, switching to a “New Drachma.” Frontier Strategy Group sees a greater than 50% chance that Greece will leave the Euro.

The referendum will most likely take place in January. As a result, companies have two months to put contingency plans in place for Greece. Companies choosing to remain in Greece will need to develop strategies to finance suppliers and distributors as credit from Greek banks will dry up. Opportunistic companies are considering using Greece as an export hub, as leaving the EU would likely devalue the local currency by 50%, making Greece an attractive long-term play from a cost point of view.

Impact on emerging markets

Greece leaving the Euro increases the likelihood of a double dip recession across Europe. European banks will take major losses in the their bond portfolios. Markets will also view a Greek exit from the Euro as a precedent for similar action in Portugal, Spain and potentially Italy. Exposure to derivates on bad debt is still unknown, compounding the uncertainty that will cause lending to dry up in both Western and Eastern Europe. Last time Europe went into recession, CEE markets, Russia and Turkey suffered disproportionately. This time, many emerging markets are more linked than before.

While many emerging markets will be impacted by the crisis, leading companies have already identified winners and are prioritizing resource allocations for those markets. India, Indonesia and Africa are set to be the biggest winners as domestic demand is driving robust growth in those markets. The Middle East and Brazil will also carry on through the crisis although they have higher linkages to developed markets because of commodities exports. China, on the surface, is positioned to outperform, but bad domestic debt and a slowing manufacturing sector are causes for concern.

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Austerity measures are not a solution to structural problems in Greece. What is at the root of the sovereign debt crisis? What are the risks? How will it impact emerging markets? Frontier Strategy Group Practice Leader, Matt Lasov answers these questions and more in an interview with EMEA analyst Martina Bozadzhieva.

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