‘Fragile Five’ 2014 Outlook: Following Currency Sell-Off, Watch For Election Uncertainty

Remember the huge selloff in emerging market currencies this summer when it appeared the U.S. Federal Reserve was going to start reducing its huge bond-buying program? While the Fed’s decision to continue its extraordinary support for the U.S. economy gives emerging markets extra time to prepare for that support to end, such preparations entail significant political risks.

Each of the five countries that were the worst hit by the summer currency sell-off is due to hold important elections in 2014. Those elections will, if anything, add to the uncertainty.

Dubbed the "fragile five" by investment bank Morgan Stanley, they are Indonesia, South Africa, Brazil, Turkey and India -- which together represent around 7 percent of the world's economy.

These countries all have large current account deficits -- the broadest measure of the trade gap -- which means that they rely on external financing. So, these countries have relied on money flowing into their borders, and now investors are pulling out as the end of the era of cheap cash looms.

The five currencies plunged the furthest peak-to-trough of all emerging economies after May 1. The Indonesian rupiah -- the biggest faller of the pack -- lost 20 percent of its value. At the other end of the scale, the South African rand dropped by nearly 13 percent.

Economic growth in all five countries has slowed recently, in large part due to structural problems. Admittedly, in Indonesia the slowdown has been relatively gradual, but India, Brazil, Turkey and South Africa are all growing at rates at least two percentage points slower than they were in the pre-crisis period.

In countries where the election result is still unclear, most notably Brazil and to a lesser extent India, political risks are high. Another concern is that incumbent governments may try to boost their re-election prospects by pushing ahead with populist spending plans, causing current account deficits to widen further. “Brazil looks most at risk on this front,” according to Capital Economics economist Gareth Leather.

“While the elections provide an opportunity for a fresh start on structural reform, only in Indonesia do we think there is a strong chance that elections will make a notable difference to the policymaking environment,” Leather wrote in a note.

Indonesia is due to hold parliamentary elections in April, to be followed by a presidential vote in July. Much of the optimism is centered on the reform-minded and youthful mayor of Jakarta, Joko Widodo. “Hopes are high that Widodo will be able to push ahead with the badly needed reforms, especially in improving infrastructure and clamping down on corruption that are needed to kick-start the economy,” Leather said.

Elsewhere, the reform outlook is not so good.

In India, some commentators have high hopes that Narendra Modi will be able to translate his success as chief minister for the state of Gujarat, onto the national stage. However, if Modi wins the premiership, he will almost certainly need support from fickle regional parties to form a majority in parliament. As such, compromise and delay are likely to continue to characterize the policymaking process in India, according to Leather. In South Africa, the ruling African National Congress’s reliance on support from the country’s powerful trade union body seriously reduces the prospects for labor market reform.

Prospects for reform in Turkey and Brazil, two countries that were hit by huge demonstrations earlier this year, are similarly uninspiring. Turkey badly needs to raise its domestic savings rate in order to reduce its dependence on overseas borrowing. However, the government will probably want to wait until 2015’s parliamentary elections are out of the way, at the earliest, before making any painful choices. Meanwhile, the falling popularity of President Dilma Rouseff in Brazil means, that even if re-elected for a second term, her government is likely to find itself in a much weakened position, further reducing the chances that she will have the authority to press ahead with pension reforms to raise the country’s savings rate, Leather added.

“Putting all this together, upcoming elections are unlikely to prove a catalyst for economic reform in the ‘fragile five,’ and in the near-term may cause sentiment towards these countries to sour even further,” Leather said.