23/09/2015

A defining moment of the 1997 Asian crisis came when Malaysia shocked financial markets by imposing draconian controls on capital outflows, banning overseas trading in the ringgit and prohibiting foreigners from taking funds out of the country for a year.

Perhaps then it is no surprise that with some commentators starting to refer to the current slump in emerging markets as a crisis, whispers of capital controls are starting to be heard once more.

To be fair, few yet believe full-blown capital controls are likely. But with external debt levels above 50 per cent of gross domestic product in a swathe of EM countries, and plunging currencies raising debt burdens in local currency terms, there are a few straws in the wind.

Tim Condon, head of Asia research at ING Financial Markets, has said it is “only a matter of time” before Malaysia either allows the ringgit to float freely or, once again, imposes capital controls, if oil prices continue to slide.

Cerno Capital, a small London-based fund manager, believes there is a “50/50” chance Turkey will impose capital controls, an eventuality that would spur “significant turmoil” in EM debt markets, it says.



Political decision

“This is not an economic decision, it’s a political decision. Because of the sensitivity of capital flows, the likelihood of them using capital controls would be quite high,” says Russell Napier, who sits on Cerno’s investment advisory committee.

A trio of crisis-hit developed world countries — Iceland, Cyprus and Greece — have been forced to introduce capital controls since the financial crisis, as has Ukraine.

Elsewhere in the emerging world, Nigeria and Ghana also have some restrictions in place to try and defend their currencies, which have fallen sharply in line with commodity prices.

With Nigeria being a major investment market, the restrictions the central bank has placed on access to dollars in order to defend the naira, might be expected to be the most painful for global investors.

That has not been the case so far. Richard Titherington, chief investment officer, emerging markets and Asia Pacific equities, at JPMorgan Asset Management, says he and his colleagues “haven’t had any difficulty taking money out of Nigeria”, despite the introduction of foreign currency quotas.

Even if the restrictions were problematic, it would still be legal for international fund managers to buy dollars at the black market rate instead, he says.



Complicated transactions

However, this may be about to change. The bank side of JPMorgan said it would remove Nigeria from its widely followed Government Bond Index by the end of October because currency controls were making transactions too complicated.

“Foreign investors who track the GBI-EM series continue to face challenges and uncertainty while transacting in the naira due to the lack of a fully functional two-way FX market and limited transparency,” JPMorgan said.

The suspension only applies to Nigeria’s local currency bonds, not the hard currency ones in JPMorgan’s EMBI index.

Anders Faergemann, senior sovereign portfolio manager at PineBridge Investments, says Nigeria’s membership of the GBI-EM index “will now be on ice for an extended period”.

However, Faergemann, who exited his Nigerian positions a year ago, says most foreign investors who are concerned about the country will have left already, limiting the impact of JPMorgan’s move.

John Ashbourne, Africa economist at Capital Economics, also doubts Nigeria’s expulsion will have a significant effect, although it is “an embarrassing blow to the Nigerian government’s economic reputation, and will add to calls for the naira to be devalued”.

The impact of any imposition of capital controls in, say, Malaysia or Turkey, could be further reaching in terms of souring sentiment towards emerging markets at large, though.

At present, most commentators do not expect controls to be introduced in these countries, but Napier believes Ankara’s predicament is shaky because Turkey’s gross external debt had already reached 50 per cent of gross domestic product at the end of 2014, according to data from the World Bank.

With more than 99 per cent of this debt denominated in foreign currencies, principally the dollar and euro, according to figures from the Bank for International Settlements, and the lira having tumbled 23 per cent against the dollar since the start of 2015, Turkey’s external debt to GDP ratio is now nearer 70 per cent, Napier argues.



Wider crisis

As the vast majority of the foreign mutual fund money invested in Turkey is held in the form of open-ended funds, which in most cases allow investors to redeem at the drop of a hat, he believes any loss of confidence in Turkey could precipitate a wider crisis.

“I’m concerned how much money open-ended funds have in Turkey,” he says. “I think it’s pretty clear that if you start to liquidate these instruments [en masse] as a foreigner you would not be allowed.”

If fund managers had to freeze the Turkish portion of their portfolios, “this would increase redemption pressure on other emerging markets,” Napier argues.

“There would need to be some events that would trigger [capital controls]. Some defaults, some large Turkish organisation being unable to make their debt repayments, but Turkey has other problems on its borders and that may give it the cover to do something,” he says.

“You have to decide whether the locals take the pain or the foreigners. [Turkey would] have to run an extremely large domestic surplus for a long time to pay [its debts] back.

“I think it’s 50/50. [Capital controls] are becoming legitimate as a policy response,” says Napier, noting that the IMF changed tack in 2012 to say targeted and temporary capital controls could be effective in calming volatile cross-border capital flows.

He has some support for his position. Tom Becket, chief investment officer at PSigma Investment Management, says: “Desperate times call for desperate measures. You are getting to a situation in some of the structurally weak emerging markets where there is now the risk of capital flight.



Challenging political outlook

“Turkey has a very challenging political outlook and problems with its borders with Syria. If things deteriorate further I wouldn’t rule anything out.”

However Titherington says Turkish exchange controls are “not a scenario that we are expecting”, given the country is a beneficiary of commodity price weakness.

“It’s possible but it’s certainly not our business case,” says Titherington, although he adds: “Risk in emerging markets is not tracking error, it’s that you don’t get your money back”.

The World Bank data show that, as of the end of 2014, the ratio of gross external debt to GDP was particularly high in much of eastern Europe, at 133 per cent in Hungary, 64 per cent in Poland and 61 per cent in the Czech Republic, for example.

Napier argues it would be a “mistake not to be worried about eastern Europe”, but remains relatively relaxed given that most of this debt will be denominated in the euro, which has not been as strong as the dollar since these figures were produced.

Instead, there has been more chatter around Malaysia, which had gross external debt of 65 per cent of GDP at the end of last year. BIS figures show this debt pile is entirely denominated in foreign currency, the bulk of which is likely to be dollars.

Steve Johnson - Financial Times