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Brexit rocks the EM boat

Brexit has sent shock waves across international markets. Although emerging markets across the globe and investor sentiment are suffering in the wake of the vote, some economies coping better than others, and overall the implications of the UK’s vote to leave could soon subside. However, future referendums across other EU member states could have serious implications for Eastern European EMs in the long run.

Jun 24, 2016 // 12:52PM

The UK has voted to leave the EU by roughly 52% to 48%. The move has caused substantial volatility across EMs globally.

UK Prime Minister David Cameron has announced he will step down in October, and suggested negotiations on the nitty gritty of the UK’s withdrawal from the Union would not commence until a new leader is in place.

European Commission President Jean-Claude Juncker said the UK should not delay negotiations on an exit, which could take up to two years, in a bid to stem long term volatility.

“We now expect the United Kingdom government to give effect to this decision of the British people as soon as possible, however painful that process may be,” he said in televised remarks. “Any delay would unnecessarily prolong uncertainty. We have rules to deal with this in an orderly way.”

Jakob Christensen, Chief Analyst and Head of EM research at Danske Bank noted that global risk sentiment has taken a serious hit. It is not only risk sentiment that has been affected – EM assets have also been impacted.

“Broadly speaking, everything has fallen,” stated William Jackson, Senior EM Economist at Capital Economics.

Despite noting that there had already been some turnaround after the sharp falls suffered this morning, Jackson added that there will be a period of high volatility.

“There will be significant uncertainty and dislocations in the financial markets over the coming days,” he said.

Currencies and fixed income instruments across certain EM geographies have been significantly affected. The MSCI EM Index fell this morning by 26.93 or 3.22% to 808.50.

“We have seen EM assets being hit fairly sharply, especially Eastern European currencies and bonds and particularly in Poland, Hungary and to some extent Romania,” Christensen stated.

According to Bloomberg, the zloty rose from 3.8345 to 4.0687 against the US dollar. The Hungarian forint fell from 275.80 to 287.99 versus the dollar and Romania’s leu fell from 3.9592 to 4.1331 against the greenback.

The yield on Polish 10-year government bonds leapt from just over 3.011% to nearly 3.250%.

Outside of Europe, other EMs have felt the aftershock of a Brexit vote. Losses appear to be largest in countries with deep and liquid markets. This explains the selloff in the Mexican peso.

The peso reached 19.2216 against the dollar from 18.2273 according to data from Bloomberg.

Christensen said that other more liquid EM currencies and fixed income instruments such as the South African rand and the Turkish lira have also been affected.

The lira fell from 2.8535 to 2.9767 whilst the rand fell from 14.4161 to 15.4926 against the dollar according to Bloomberg.

South Africa’s large external vulnerabilities make it more dependent than most EMs regarding foreign currency financing, resulting in a more susceptible rand.

However, Asian EMs have not been hit as sharply as their peers on the results of the UK’s referendum. This is especially true of their currencies and bonds.

“The currencies are only down between 1% and 2%. There is much less movement there than in other markets,” noted Christensen.

Asian EM currencies such as the Thai baht, Malaysian ringgit and Chinese yuan only moved slightly.

The baht only fell from 35.121 to 35.485 against the dollar, whilst the yuan fell from 6.5807 to 6.6080.

The ringgit, being slightly more liquid, fell from 4.0165 to 4.1283, although still recorded a smaller fall than its European counterparts.

Despite the volatility caused by the immediate impact of the vote, the broader macroeconomic effect on EMs globally is likely to be limited.

Jackson noted that trade and financial ties between EMs and the UK are generally quite small, and a sharp economic slowdown in Britain following a vote to leave would have a minimal impact.

“From a 10% fall in UK imports, the decline in EM exports to the UK would be just 0.1% of aggregate EM GDP, which is pretty small in grand scheme of things.”

He added that the risks were greatest in CEE region. “But even then the risks are small; the UK accounts for only 2 to 5% of exports and 2 to 5% of investments.”

The limited impact on the majority of EMs, could actually lead to a pickup in their assets by international investors.

“We had been advising clients that there may be opportunities to buy EM assets across the sector following a possible Brexit,” Christensen said.

EMs are likely to receive slightly more breathing space in the longer term following the referendum’s results.

“We expect the US Federal Reserve to be on hold for longer following the referendum results. We expected it to come in September but are now expecting it to come next year,” stated Christensen.

He added that this explains why there has not been a significant shift in the bond and currency markets across Asia, noting that the impact on Latin American countries would also be limited. Although market volatility will likely remain for around two weeks, calm is likely to descend again in the near future.

However, analysts said there would be uncertainty going forward around whether other countries in Europe would hold their own referendums.

“The litmus test will be in Spain with the election this weekend. If Podemos (the left-wing populist party) do well, it could signify a leave sentiment which may add to uncertainty,” he noted.

“The big question is whether we will end up with a two-tier Europe.”

Jackson stated that further separatist movements across EU could emerge, but would likely happen within the next 5 to 10 years rather than the next 2 to 3.

He continued that the risk across Eastern Europe lies in the politics.

“Across Eastern European governments there could be a backlash against EU oversight on policymaking and a turn towards more populist policies.”

This would hurt investment in the region and dampen growth prospects over the medium term.

EMs aside, notwithstanding the many economic implications of Brexit on the UK, the role of the City of London as a centre for financial transactions could be affected. Despite the pound falling on the results of the vote (from 1.4877 to 1.3463 to the dollar), the City of London is likely to remain the centre for financial transactions across Europe, according to Christensen.

“I am sceptical about whether London will lose its title as the European financial centre, especially over the next year. It has established itself as a leading centre for a while,” he said, adding that he was unsure whether other financial sectors, such as in Paris, could take on the role.

Europe Macro Policy & Government

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