Emerging currencies pay price for end to cheap money

Beware the vagaries of fashion. For the past decade, global capital has been drawn to emerging market currencies like bees to a honey pot, helping fund consumer booms from the suburbs of São Paulo to the souks of Istanbul. Now much of that capital is taking flight, leaving emerging market governments with a current account headache and some very tough choices.

Since US Federal Reserve chairman Ben Bernanke signalled in May a potential tapering of the central bank’s massive bond-buying programme, emerging markets investors have backed off, withdrawing more than $52bn from bond and equity funds since the beginning of June, according to data provider EPFR Global.

The resulting decline in currency valuations has been stark. The Brazilian real has lost about 11% against the dollar so far in 2013, while the Indian rupee has declined 16%. The Indonesian rupiah is down 12% and the Turkish lira has dropped nearly 13%. The MSCI Emerging Markets Currency Index, which tracks performance relative to the US dollar, has fallen by more than 5% since its high in early May.

The problem for some emerging market countries is that without the foreign currency investment to which they have become inured, they will struggle to finance their current accounts.

“Since the middle of the previous decade, emerging markets saw consumption kick in very fast and the current account started expanding, with a subsequent deterioration in surpluses,” says Luis Costa, an emerging markets foreign exchange strategist at Citi in London. “That was not a problem when the world was feeling the force of quantitative easing, supplying endless liquidity to emerging markets, but once the Fed decided to change gear we saw a reluctance to continue that financing.”

Fragile five

Morgan Stanley strategists have branded the South African rand, Indian rupee, Brazilian real, Indonesian rupiah and Turkish lira the "fragile five", because of the difficulties the countries face in attracting foreign capital.

The impact of outflows from emerging markets has been particularly felt in the fixed-income space, where the average spread to US treasuries has widened, presenting investors with a painful combination of higher rates and lower currencies. Aberdeen Global’s Emerging Markets Local Currency Bond Fund is down 13.87% since the beginning of the year, while Pimco’s Emerging Local Bond Fund has lost 11.57% in the year to date.

From an economic point of view, there is little evidence to suggest the impact of a rise in the benchmark Fed rate has played out, and the worst-case scenario is a structural long-term shift in the supply of capital flows towards emerging markets.

Unfortunately, sharp devaluations in foreign exchange will not necessarily lead to a reverse in current account performance, and a recent note from Citi said there was little evidence in past emerging markets foreign exchange sell-offs of a jump in external demand following depreciation. Currently in countries such as Brazil, the opposite trend is in play, with domestic demand continuing to rise on the back of double-digit credit growth.

“In the most fragile countries the troublesome balance of payments comes from too-strong domestic demand,” says Bartosz Pawlowski, head of central and eastern Europe, the Middle East and Africa foreign exchange strategy at BNP Paribas in London. “Ideally countries need to manage that lower, but it’s tough to achieve without domestic pain, which of course is politically very challenging.”

Who will cope best?

With elections next year in Brazil, India and Turkey, the prospect of a sharp forced readjustment in domestic demand is likely to be unpalatable. Instead governments may prefer trying to continue funding the current account, either through direct intervention or the more conventional use of monetary policy. However, the ability to employ policy tools varies considerably across the fragile five, which from an investor point of view may comprise a useful guide to prospects for individual currencies.

The country with seemingly the most ammunition in its locker is Brazil, which has $370bn of foreign currency reserves, equivalent to about 18 months of imports, and which has already said it has put aside $50bn to $60bn to protect the real. With inflation at the upper end of its target range, the country's central bank, led by Alexandre Tombini, also has the possibility of raising its key Selic interest rate further, after 175 basis points of rises this year.

“Brazil is determined to maintain its anti-inflationary policy through higher interest rates and also has foreign exchange reserves, which it has said it will use to defend the currency,” says Thierry Apoteker, chief executive of emerging markets risk consultancy TAC Financial. “That puts it in the lead position among the fragile five in terms of its ability to stem further losses in the real.”

At the other end of the scale in terms of defence capability is Turkey, which has low reserve levels and a central bank and political establishment that have made no secret of their aversion to higher interest rates at a time of slowing economic growth, alongside rising concerns around the country’s proximity to the war in Syria.

Rates hikes controversial

India and Indonesia are in the middle of the scale of capabilities, with both countries facing constraints in their ability to raise rates. India had $257bn of foreign currency reserves at the end of July, and has already spent some money defending its currency. However, a key question for new central bank governor Raghuram Rajan will be whether the country can afford to lift rates at a time of economic slowdown.

Mr Rajan, a former chief economist for the International Monetary Fund, is a renowned monetary policy hawk, and his appointment has been met in India with the kind of adulation usually reserved for film stars. However, if he anticipates an easy ride in raising rates, he is likely to be disappointed. The Indian economy is growing at its slowest rate since 2009 and a hike has been vociferously opposed by the business community, with some influential voices calling for a cut.

Such has been the level of concern over currency declines that China, Brazil, India, Russia and South Africa agreed in September to pay into a $100bn swap fund to support emerging market currencies.

Russian president Vladimir Putin announced the initiative at the G-20 meeting in St Petersburg, amid increasing signs central banks are coordinating to protect their currencies. China, owner of the world’s largest foreign reserves, committed $41bn to the fund, with Brazil, India and Russia each committing $18bn. South Africa said it would contribute $5bn.

Looking for value

As politicians and policy-makers in emerging markets ponder the impact of currency declines, the inflationary impacts of which must be balanced against increased competitiveness, investors may be making a similar type of calculation. Last year, currency markets were tough globally because a lack of volatility undermined trading strategies. Now volatility has returned and with it differentiation between countries, which presents both challenges and opportunities.

“It was hard to find value earlier this year because everything was bid up,” says Javier Corominas, head of research and foreign exchange strategy at Record Currency Management in London. “Now we are starting to see some pockets of value, particularly in eastern Europe, where we are long on Hungary and Poland.”

Meanwhile, performance among emerging markets varies considerably, with currencies such as the Korean won, Taiwanese dollar and Thai baht performing relatively well in the recent period. The Hungarian forint has lost just 3% of its value against the dollar this year, a surprising performance given the difficulties with the country’s budget and banking sector.

“The bulk of emerging markets look in relatively good shape compared with earlier episodes [of currency volatility],” says Mr Corominas.

Interestingly, however, some of the relative advantages of specific economies may be being masked by the dynamics of modern investing, and in particular the rise in importance of exchange traded funds (ETFs), which buy and sell currencies based on broad-based indexes. ETFs in the words of one investor tend to “tar everybody with the same brush, so that even the best will suffer to some degree”.

Oil winners and losers

Still, identifiable classes of currency remain, and one that has been relatively insulated against the sell-off is the group whose fortunes are tied to commodity exports, and in particular oil, which has risen on the back of factors including instability in Syria, strikes in Libya and declining supply from Iraq. The front month price of a barrel of Brent crude rose in recent weeks to $117.34, a six-month high, while US West Texas Intermediate hit $112.15, the highest level since May 2011.

For exporters such as Russia and Mexico, the rising price of oil has been a boon, and that has been reflected in their currencies. Of course, on the other side of the equation the higher crude price is negative for countries reliant on imports, such as India, Turkey and Thailand, all of which could do without the inflationary impact on their economies. Turkey imports more than 90% of its crude oil, while India is the fourth largest importer of oil in the world.

“There is a strong positive correlation between trade deficits and oil prices in Turkey and India,” says Alvin Tan, a foreign exchange strategist at Société Générale. “Higher oil prices will also damage growth prospects and increase inflationary pressure, none of which is good news for the currency.”

One emerging market country to have seen consistent currency appreciation is China, where the renminbi has risen about 1.5% against the dollar this year and has gained on average between 2% and 2.5% over the past eight years. One of the reasons for the renminbi’s performance is the tight grip the Chinese authorities maintain over capital flows, and China is not a big seller of foreign exchange reserves. However, those capital controls also make it difficult for investors to get exposure.

“There are still not many ways to invest in the renminbi, despite the introduction of a qualified foreign investor scheme,” says Qinwei Wang, China economist at Capital Economics in London. “The currency is still under the control of the People’s Bank [of China] and China’s huge trade surplus remains fundamentally undervalued. We see appreciation continuing at a rate of 1% or 2% a year.”

As investors wrestle with relative value trades, an interesting debate is emerging over how best to value emerging market currencies in a new age of limited liquidity, and some observers says the current account measure may be a red herring.

“Many of the most fragile countries received lots of capital which pushed up growth in a way that was not sustainable,” says Robert Savage, chief strategist at New York-based hedge fund FX Concepts. “The issue is not the current account, it is leverage. While you have a lot of countries trading at capacity, the real problems are labour reform, productivity and poorly allocated capital.”

Volatile times

For short-term traders, meanwhile, activity has been constrained by soaring levels of volatility. Traders usually profit from volatility, but not this time. Prices have been moving too quickly in one direction, leading to a drop in trading volumes and so-called gappy pricing.

As an investor, volatility has become a key benchmark, says Mr Savage. “The best yield is defined by volatility and so you are looking for the highest yielding stable currency.”

From a market-maker point of view, the restrained liquidity environment has also been far from ideal. “Higher volatility is better for investors in general, but if it goes too high too fast then it becomes frightening and people step away from market,” says one banker in London. “It has definitely been a more interesting time but flows have been lower so it has not necessarily been more profitable.”

With US interest rates almost certain to rise in the coming months, the flow of cheap money that has sustained emerging market current accounts and currencies is unlikely to return any time soon. However, there is some suggestion that rising US treasury yields may stabilise after their recent surge, according to economists at TAC. That may mean the worst for emerging market currencies is over.

“We expect a gradual economic acceleration,” says TAC’s Mr Apoteker. “Presuming US 10-year yields stabilise below 3.2% and assuming the short-term relationship between emerging market currencies and US yields continues to hold, this would imply that the present intensity of depreciation pressure is likely to steadily ease as we enter 2014.”