The Fragile Five: Economics undone by Politics

Five currencies have been named by Morgan Stanley as the ‘Fragile Five’ – the Brazilian real, the Indonesian rupiah, the South African rand, the Indian rupee, and the Turkish lira. The ‘Fragile Five’ economies are finding it increasingly difficult to attract foreign capital to finance trade deficits hence appear to be vulnerable to the much anticipated tapering of the Fed. High inflation, weakening growth, large external deficits, high dependence on fixed income inflows and also slowing down of China, make these economies and therefore currencies vulnerable.

The fragility appears in the emerging economies at large. This can be attributed to the sudden divergence in growth rates of the emerging economies and the developed economies. With the U.S. growing at an annual rate of 4.1 percent in the third quarter of 2013, with the manufacturing and employment figures moving north and strong, with the purchasing managers’ index for U.S. jumping to 57 percent in January 2014, the world has a stronger and power packed U.S. dollar.   The currency market has also witnessed surprising gains in Japan’s yen, the Swiss franc and the Euro. Compare this to developing-nation industrial output being at a four-year low with China’s slowdown cutting demand for everything from Brazilian iron ore to Malaysian palm oil. Emerging countries accounted for nine of the 10 worst performers among 31 major currencies tracked by Bloomberg, 54 percent of companies in the MSCI Emerging Market Index of stocks have reported second-quarter earnings that trailed analysts’ forecasts compared with 35 percent for members of the developed-economy MSCI World Index, according to data compiled by Bloomberg.

All the emerging economies are vulnerable to the fears of capital outflows after the Fed’s tapering. The ‘Fragile Five’ have been hand picked from amongst the already vulnerable lot. These are the five emerging economies with weak fundamentals, especially those with “twin deficits” in their budgets and current accounts, weak growth rate compounded by one more common factor that adds to their vulnerability that is the imminent scheduled elections. This last element in the list of weaknesses draws the common thread in the ‘Fragile Five’ that brings in the risk in the economic environment leaving them exposed to tapering.

Brazil has been slow in bracing itself for the tapering. It is already burdened with a growing government budget deficit and inflation. Brazil has resorted to using price controls on fuel to arrest inflation. Brazilian real had fallen by more than 15 percent each since the Fed’s announcement in May 2013. Tough structural unpopular measures are not likely to be implemented until after the election. Easy money till recently has escalated the amount of debt where the credit to the private sector has doubled in the past five years to 50% of GDP. Any new reforms taken now will lead to a weaker currency, higher inflation and higher interest rates.

India has been worst hit in terms of its currency in August 2013 in anticipation of the Fed taper. Although fears over the impact of the taper have been assuaged through measures adopted by the Reserve Bank of India with a stringent control on gold imports, opening a  special foreign-exchange swap window to provide dollars to state-run oil refiners has taken some pressure off the rupee  coupled with a scheme designed to attract savings investment from Indian expatriates. Currently is bogged down with rising inflation and falling industrial production, persistent fiscal deficit and recently controlled current account deficit. In order to check the fiscal deficit, the planned government spending has been drastically reduced with long term repercussions on growth and unemployment. Turkey’s vulnerability stems from paucity of foreign direct investment along with low level of labour participation and a sliding savings rate. Turkey’s weakness stems from over dependence on hot money with nearly 80 percent of its current account deficit being financed by short term loans rather than foreign direct investment. This ailment is compounded by political tribulations including the country’s first presidential election on the horizon and internal hostility in the coalition.

In South Africa, the GDP to is expected to dip below 2 per cent down this year from a peak of 5.6 per cent in 2006. The situation is worsened by strikes, unemployment levels at a high of 25 per cent and high poverty rates are further compounded by a widening current account deficit of 6.8 per cent. The government has initiated austerity measures to control fiscal deficit and boost exports but the looming elections for the African National Congress bring in the element of uncertainty. The government needs to implement austerity measures along with attempts to boost growth and exports and reduce both the deficits.

The Indonesian currency has lately coming under a great deal of pressure with its current account widening to its worst since the Asian crisis of the late 1990s. The depreciated currency is partly to blame for the rising inflation. The growth rate has slowed down with the manufacturing slowing down due to high inflation, the depreciating rupiah, higher interest rates and higher minimum wages. The economy is also vulnerable to the a third of government debt being owned by the external sector. Any structural reforms will need to wait till the new government takes office in 2014.

These economies are bracing for the tapering in their individual manner with India being confident bolstered by increased foreign exchange reserves and declining current account deficit. Bank Indonesia (BI) has raised interest rates several times in the recent past, South Africa has introduced measures to control fiscal deficit, create a climate of confidence and attempted to boost exports. Of the five, Turkey seems to be the most fragile. Turkey faces turbulence not only from the political strife but also the myopic economic policies adopted by the central bank to use foreign reserves to prop up the lira rather than tighten policy.  Closely following Turkey in fragility is Brazil. It’s weakness stems from inertia with Brazilian authorities biding time until after the elections to bring in the much needed structural reforms.

The fragility of these currencies is more to do with timing of the tapering and the winds of political change. These economies have either taken smaller measures than needed or shown indecisiveness in implementing difficult structural reforms to strengthen the economy despite being aware of the Fed’s intent of initiating tapering. In times of capital flows uncertainty, the differentiating characteristic of the ‘Fragile Five’ is the difference between a surplus and deficit economy. The ‘triple deficits’ is the key differentiator making these emerging economies the ‘fragile five’ – the current account deficit,  fiscal deficit and governance deficit.

Contributed by Prof.Swaha Shome and Prof. Davinder Suri (Faculty, IBS Mumbai)

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