By Win Thin
The Libyan situation continues to deteriorate, with the expected impact on oil (up) and EM (down) being seen today. Libyan leader Qaddafi is hanging on to power despite reported defections by diplomats and soldiers, while his son threatened “rivers of blood.” So far, the Libyan response to the protests has been much bloodier than those seen in Egypt and Tunisia. The dollar, yen, and Swiss franc are the beneficiaries, with the greenback outperforming the other two today. The contagion that started in Tunisia has now spread to important OPEC member such as Libya and Iran, and ongoing protests in Bahrain have raised concerns that ripple effects on Saudi Arabia will be felt too.
Markets have always relied on Saudi Arabia to act as the swing producer, boosting output if supplies were disrupted elsewhere. We note that it currently has excess capacity of around 3 mln bbl/day, which would cover Libya’s daily output of 1.6 mln bbl. Within OPEC, the other big producer facing substantial unrest is Iran, whose daily output of 3.7 mln bbl is too large for even Saudi Arabia to replace right now. Oil markets are pricing in continued contagion, it would seem, with Brent crude trading close to $110 and WTI moving closer to $100. Surging oil prices are not what the global economy needs right now, and so we would expect global equity markets to start reflecting these heightened risks.
Foreign equity outflows from some EM countries have been seen in 2011, but the amounts are dwarfed by the inflows seen in 2009 and 2010. For instance, India has seen the largest foreign equity outflows this year in Asia of -$1.6 bln YTD. However, 2009 inflows were $18 bln and 2010 inflows were $29 bln. Similar trend is seen in Korea, and so we feel confident that investors overall are comfortable with the EM story. Still, the unsettled nature of Middle East politics suggests EM equities and currencies are likely to remain under pressure near-term. We do see eventual decoupling, but the past year has shown us that increased sovereign risk, both developed (Greece, Ireland) and EM (Egypt), can have significant short-term impact on EM assets.