Capital Economics: four questions on Brexit
Capital Economics outlines four common questions they have fielded from clients on Friday, following the UK's historic decision to exit the European Union.
• #1: How long will the market turmoil last and will there be a lasting impact on capital flows to EMs? It goes without saying that we are in a period of huge uncertainty but there are already early signs that the flight to safety has started to ease. The Mexican peso is the most heavily traded EM currency and a bellwether for investor sentiment - it sold off heavily in the initial aftermath of the vote, but has since recovered some lost ground. (See Chart 1.)
• Meanwhile, there has so far been few signs of stress in EM banking systems. Interbank interest rates in most of the EMs that publish daily fixings have either been stable (Poland, Turkey, Hungary, Czech Republic and Taiwan) or have edged down (Russia and Malaysia). It's still early days but there has so far been no sign of a collapse in counter-party confidence.
• One reason for thinking that this might continue to be the case is that central banks in the developed world have plenty of ammunition in the event that global credit markets do freeze up. The Bank of England has already begun to talk about liquidity injections. Other central banks in the developed world (notably the ECB) could step up policy support too. All of this should help to calm the mood in financial markets and ultimately limit capital flight from EMs.
• #2: How will policymakers in EMs respond? Much depends on whether we're right in thinking that the impact on financial markets will be short-lived. If we're not and there is widespread flight from EMs then economies with large external financing requirements (notably Turkey and South Africa) could be forced to raise interest rates. As things stand, however, we think that the initial response of central banks will be to intervene in foreign exchange markets where necessary to limit large falls in currencies and keep rate hikes as a last resort (one exception is Mexico, where the drop in the MXN today strengthens the case for rates to be raised at next week's policy meeting). In Central & Eastern Europe (CEE), central banks would respond to aggressive action by the ECB with further rate cuts, but this is not yet our base case.
• #3: Are we changing our GDP forecasts? Not yet. Assuming the dust settles in financial markets the fallout for EMs should be limited. A prolonged period of market dislocation would warrant downgrades to forecasts, with a focus on CEE and EMs with large external borrowing needs (Turkey, S. Africa).
• #4: What are the wildcards to watch for? Three things stand out. The first is signs of stress in global banking systems. While it's tempting to look at financial ties to the UK (strongest in Africa), the weakest link is banks that rely heavily on external wholesale markets. A decent proxy for this is banks' short-term external debt. (See Chart 2.) On this measure, banks in CEE, Turkey, South Africa and Malaysia look exposed. Second, while the direct economic impact on EMs could be surprisingly small, the political ramifications for EMs in the EU could be significant - populists in CEE will be emboldened by the vote. Finally, in the event that the Chinese RMB weakens against a globally strong dollar following the vote, this could rekindle devaluation fears. One crumb of comfort here is that the RMB's trade-weighted weakening over the past 12 months gives the People's Bank some leeway to allow the currency to track the dollar higher if necessary in order to avoid a repeat of the panic seen earlier this year.
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