By Laura Cooper and Frederique Carrier

EM currency dominoes?

Investor fears of widespread financial stress sent EM currencies tumbling in August, aggravating earlier pressures from rising U.S. interest rates and attendant dollar strength.

The bulk of the weakness was confined to countries facing unique headwinds, namely Argentina and Turkey, and those showing the greatest vulnerability to tightening global liquidity.

During 2017, the combination of commodity prices rallying, healthy growth prospects, and still lowly valued but strong EM equity markets led global and U.S. investors to reallocate their portfolios to assets outside of the U.S. in search of greater yields. This contributed to global fund flows into EM equities and the MSCI Emerging Markets Currency Index rallied to record highs by early 2018.

Emerging market currency weakness has been contained
Currency movements against the dollar indexed to 100
contagious currency crisis chart 1

EM currencies came under pressure in 2018 on the back of rising U.S. rates; although sharp declines have been limited to countries facing idiosyncratic challenges.

Source - Bloomberg, RBC Wealth Management

However, rising U.S. Treasury yields against a backdrop of growing expectations for Federal Reserve rate hikes and U.S. dollar strength sparked an about-face for EMs by April 2018. The tightening in global financial conditions underpinned the selloff in EM currencies through July. Then, a sudden flare-up of events in August spurred concerns that broader EM fragilities could be brewing under the surface.

The MSCI Emerging Markets Currency Index fell from a record high in April to a 17-month low in September. So far this year, the Argentine peso has plunged by more than 50 percent, followed by the Turkish lira (-40 percent), Brazilian real (-20 percent), and South African rand (-15 percent), all despite interventions by central banks to prop up battered currencies.

The behaviour of EM currencies is important because it often sets the tone for EM equities and fixed income. It’s no wonder EM equities have lagged in recent months, falling 10 percent since April compared to a gain of six percent for the MSCI World Index of developed markets and 11 percent for the S&P 500 (all in U.S. dollars).

Containing contagion

The EM countries whose currencies have experienced stress are those with the weakest fundamentals: high current account deficits, low foreign currency reserves, and weak fiscal positions. Uncertainty around elections and proposed reforms are further dampening investor confidence in countries like Brazil and Indonesia.

While there are still headwinds ahead for EMs with more rate increases from the Fed in the pipeline and other developed economies dialing back monetary policy stimulus, pronounced and prolonged currency selloffs should be limited to countries where fundamentals are deteriorating, in our view. Timothy Ash, EM senior sovereign strategist at BlueBay Asset Management,1 believes contagion risks should be controlled (see Despite troubles in Turkey and Argentina, it’s not all over for emerging markets).

Gauging the risks amongst emerging market countries
contagious currency crisis chart 2

* Credit default swap spread can be considered to be the price, in basis points, of insuring against default of the underlying fixed income asset; i.e., the higher the price, the greater the likelihood of default. Source - Bloomberg, RBC Wealth Management

Finding footing

There are a number of reasons why the broader EM backdrop, while bruised, remains constructive, in our view. In aggregate, EMs appear poised to remain the engine of global economic growth, gaining more ground against developed economies through 2019, at least. Relatively healthy economic fundamentals, despite notable exceptions, alongside attractive EM asset valuations should cause concerns of widespread fragilities to eventually fade.

Moreover, in our view, policy stimulus in China, ongoing EM reforms, and central banks employing measures to contain pressures should keep a lid on a spillover of idiosyncratic vulnerabilities. Pain could persist in pockets of EMs, though we believe the sharp currency rout should begin to abate.

Key risks to our view include escalating U.S.-China trade actions, a potential economic slowdown in China feeding into broader emerging economies, and further capital flows into the U.S., attracting assets away from riskier EM securities.

Chain reaction?

The crosscurrents that blew across EMs are likely to impact some developed banks due to their lending activities. Turkey is a case in point. Volatility has recently abated following the Turkish central bank’s unexpected and aggressive rate hike that shored up the lira, but the country remains in the eye of the storm. Nonperforming loans are likely to spike with local interest rates now exceeding 24 percent. In addition, with 40 percent of Turkish loans in foreign currency for the banking system as a whole, the devaluation of the lira will make it more difficult for those who use local currency revenues to repay their foreign currency loans.

European banks are likely to bear the brunt of this. Their exposure to Turkey is greater than that of their U.S. counterparts, though in aggregate it remains relatively small. According to the Bank for International Settlements, the loan exposure to Turkey of Spanish, Italian, and French banks is equivalent to 1.9 percent, 0.5 percent, and 0.4 percent of total assets, respectively. By comparison, U.S. banks’ exposure represents a mere 0.1 percent of total assets.

Foreign banks’ claims on Turkey
A hit on Turkey would be manageable
contagious currency crisis chart 3

Source - Bank for International Settlements, Bloomberg

Specifically, the three European banks most exposed to Turkey have stakes in Turkish banks: Spain’s BBVA (49.9 percent stake in Turkiye Garanti Bankasi), Italy’s UniCredit (40.9 percent stake in Yapi ve Kredi Bankasi), and France’s BNP (72 percent stake in Turk Ekonomi Bankasi), according to RBC Capital Markets.

Should the Turkish exposure be written off, RBC Capital Markets calculates it would represent a 12 percent, six percent, and three percent hit to book value, respectively. BBVA is the most exposed but the hit would likely still be manageable. Dutch bank ING also has some exposure that should be similarly manageable as its Turkish business accounted for less than two percent of the bank’s tangible book value in 2017.

The question is, what if contagion spreads within EMs?

This is not our base-case scenario, though highly indebted countries facing hefty debt rollovers may well find it more difficult to procure financing in the current environment. In particular, Argentina, Turkey, Brazil, Indonesia, and Colombia all have to pay a substantial portion of their external debt within the next year.

Overall, our heat map of potentially problematic countries indicates that beyond Argentina and Turkey, the most at risk are Brazil, South Africa, Colombia, Indonesia, Mexico, and Chile.

Here again, exposure to potential problem countries seems to be most acute in Europe. Spain appears most vulnerable with exposure to the most fragile EM economies adding up to more than 160 percent of its banking system capital and reserves. Other European countries are much less directly exposed, though French banks have large exposure to Spain, while German banks have large exposure to France.

Foreign loans in most-challenged EMs as a percentage of total country bank equity
contagious currency crisis chart 4

Spanish banks’ EM exposure dwarfs that of other nations.

Source - Bank for International Settlements

Broadening the exercise to all EM countries, the European and U.K. banks that are most exposed to EMs are Spain’s BBVA and Santander (due to Latin American exposure) and the U.K.’s HSBC and Standard Chartered (due to Asian exposure). For U.S. banks, Citi is most exposed, with some 32 percent of revenues generated in EMs, of which 15 percent is in Asia, 13 percent in Eastern Europe, Middle East, and Africa, and four percent in Latin America.

European banks’ emerging markets exposure by region
contagious currency crisis chart 5

Middle East & North Africa




Exposure to Latin America is behind Spanish banks’ large EM exposure.

Source - RBC Capital Markets


At this stage, EM stress seems relatively contained with Argentina and Turkey in particular in the crosshairs. While these countries have further to go to stabilize their currencies and financial systems—even if the process involves volatility and bumps along the way—we believe contagion risks are relatively limited for the wider EM universe, global financial system, and developed market banks.

This is not the late 1990s when a number of EM countries were vulnerable to contagion. More EM countries have positive current account balances, external debt denominated in local currencies, higher currency reserves, and free-floating exchange rates. These factors do not automatically immunize currencies and financial systems from stress, but they should contain it, in our view.

European banks are more exposed to volatility and stress in EMs than their U.S. counterparts. But as long as contagion remains confined, we would expect them to weather the difficulties.

Required disclosures

Research resources

BlueBay Asset Management is one of Europe’s largest specialist active managers of fixed income with over $59.6 billion in assets under management in corporate and sovereign debt, rates, and foreign exchange (as of June 30, 2018). Its investment philosophy and approach focus on delivering absolute-style returns, with an emphasis on capital preservation. BlueBay is a wholly owned subsidiary of Royal Bank of Canada with full investment autonomy and substantial operational independence.

Non-U.S. Analyst Disclosure: Frédérique Carrier & Laura Cooper, employees of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (U.K.) Limited; contributed to the preparation of this publication. These individuals are not registered with or qualified as research analysts with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since they are not associated persons of RBC Wealth Management, they may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.