Emerging market currencies benefited handsomely from the US central bank’s huge quantitative easing programme. With that now being unwound and with China slowing, emerging currencies are now in retreat. Those from economies with weak fundamentals are especially vulnerable. 

 

Emerging market currencies are stuck between a rock and hard place. To the west, the US appears in the midst of an economic acceleration, while to the east, China is slowing.

For some of those in the middle, the great economic powers have got it the wrong way round. The better scenario for them is the one which previously played out. In that case a booming Chinese economy reflected its good fortune on its emerging market peers, while a weaker US flooded the world, and particularly emerging markets, with liquidity through its attempts to stimulate its economy. 

 

US growth

With the US now emerging from one of its most extreme winters in decades, the consensus among economists is that the world’s largest economy is likely to renew the positive momentum it started to create in 2013. The implication is that the Federal Reserve’s liquidity tap will continue its slow rotation toward the off position, and that the waves of dollars that boosted emerging market currencies over recent years will recede.

“The cold US winter had a negative impact on job creation and economic activity, but we do expect that stronger growth will resume,” says Sébastien Barbe, head of emerging markets research and strategy at Crédit Agricole. “The political situation in Ukraine has also had an impact on sentiment, but once the dust settles we expect to see US Treasury yields resume their rise.”

The stark impact of higher US rates on emerging market currencies was illustrated in May of last year when the Fed’s then-chairman, Ben Bernanke, signalled that the central bank’s exceptional monetary operations, known as quantitative easing (QE), would soon be ‘tapered’ in response to the emergence of the country from the financial crisis.

In the months following Mr Bernanke’s announcement, capital flows to emerging markets, which had run at billions of dollar a month in the second half of 2012 and first few months of 2013, turned sharply negative, with $30bn of outflows from emerging Asia and Latin America in June alone, according to the Fed.

The change in capital movements was felt across asset classes. It became even more pronounced in the early part of this year, when some $19bn was withdrawn from emerging market equity funds in the first two months, according to data provider EPFR Global.

From the beginning of 2013 until the end of February 2014, EPFR-tracked developed market equity funds gained more than 27% on average, while emerging market equity funds lost more than 5%.

 

Onshore movements

Another driver of emerging market currencies is onshore movements of capital, particularly the dollarisation of domestic accounts.

“If you look at Russia, you see increasing dollarisation of domestic accounts, while Turkish households have been buying dollars fairly consistently as well,” says Giles Page, Citi’s head of foreign exchange (FX) for central and eastern Europe, the Middle East and Africa. “In the end it’s a mixture of foreign and domestic capital flows that are impacting currency markets.”

For emerging market currencies the flight of capital meant only one thing: downward pressure. The Indonesian rupiah lost 23% of its value versus the dollar from May to December last year, the Brazilian real lost 10%, the India rupee weakened 9% and the Turkish lira fell 15%. South Africa’s rand went down 5% in that period. Such was the scale of losses that those countries became known as the ‘fragile five’.

For the fragile five, there was no respite at the beginning of this year. The lira fell 4.5% against the dollar over the course of January, its weakest start to a year since 2009, the real lost 2.6% of its value and the rand collapsed by 7%. Other countries were hit, too. Russia’s rouble shed 7.1%, its worst January in five years.

For those seeking a scapegoat, the US, because of its unwinding of QE, was an obvious target. However, there are also more complex forces at play, and even as emerging markets have broadly sold off, some countries have performed much better than others. That, analysts point out, is because currency movements are the result not just of external pressures, but also internal economics.

“When you look at emerging markets you are always focusing on both the external environment and domestic factors,” says Mr Page. “Following the initial sell off on tapering concerns, expectations for higher US rates have stabilised. There may be a move higher in US rates as better numbers start coming in and the impact on emerging markets may accelerate again. But in the meantime investors are focusing on emerging market fundamentals, and there is no doubt some countries are struggling more than others.”

 

Overvalued currencies

The countries whose currencies are most under pressure share some common attributes, chiefly large current account deficits that are often combined with a heavy reliance on short-term foreign currency borrowing.

“The Fed tightening monetary policy is a trigger for the emerging market moves but it is not the cause,” says Thierry Apoteker, chief executive of emerging market consultancy TAC Financial. “The moves had to happen [eventually] because liquidity was so great that inflows into emerging markets pushed currencies into significant overvaluation.”

The problem for the fragile five is that they all have large current account deficits, the result of over-valued currencies leading to excessive demand for imported products over the past few years. “If the currency was not overvalued, domestic demand would be lower and you would have better export performance, leading to a smaller deficit and stronger growth,” says Mr Apoteker.

Countries looking to combat significant current account deficits and weak currencies have two potential weapons at their disposal: policy rates and foreign currency reserves. India, Brazil, Turkey, Indonesia and South Africa have raised rates in recent months, which has had the dual benefit of cooling domestic demand for imports and protecting their exchange rates from further declines.

Of the fragile five, probably the most vulnerable, on the basis of its current account deficit and level of FX reserves, is Turkey. Unlike a country such as Brazil, which has about $350bn of reserves and has said it will use up to $60bn to defend the real, Turkey, which has much lower reserves of roughly $115bn, cannot easily intervene to protect the lira.

In addition, Turkey’s gross external financing needs are more than 20% of gross domestic product (GDP), and current reserve levels appear inadequate to cover short-term debt redemptions, which this year stand at about $168bn, a total which does not include long-term debt maturing in the same period. Economists say Turkey is in an uncomfortable position, especially given that its short-term financing has tended to come from portfolio flows, which are now in retreat.

 

Politically vulnerable

Recent events have shown that investors will be selective in their response to the prospect of declining global liquidity, with the largest capital outflows seen in countries where economic fundamentals are weaker, or where there are political tensions, for example in Russia and Ukraine. “The currencies we see as most vulnerable to tapering and to rising Fed rates are Venezuela and Turkey primarily,” says TAC’s Mr Apoteker, pointing to two countries that have experienced a rise in political unrest over the past year.

Idiosyncratic circumstances demonstrate “how important it is for emerging market countries to improve their domestic fundamentals as global monetary conditions return to normal,” said Fernanda Nechio, an economist at the Federal Reserve Bank of San Francisco, in a note in March.

The outlook for China’s economy is another factor likely to have a growing influence on emerging market currencies. There, credit-fuelled growth has raised concerns about a financial crisis.

In the first quarter of 2013, each $1 of credit added the equivalent of 17 cents to China’s GDP, down from 29 cents the previous year and 83 cents in 2007, according to data compiled by Bloomberg.

“The ability of China to create added value [through credit] has decreased,” says Crédit Agricole’s Mr Barbe. “While we don’t see China facing payment difficulties we do think the expectations are likely to be more negative, which may impact emerging markets closely connected to China.” Countries fitting that description include Asian economies and commodity producers such as Chile, adds Mr Barbe.

With the US only set to continue tapering and with China having to deal with a debt bubble, it may be a long while before the good times return for emerging market currencies, particularly those with weak fundamentals.

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