David Woo, head of global FX strategy at Barclays Capital

Currency strategists are increasingly looking towards the emerging BRIC and commodity economies to secure future profits. But how sustainable is this tactic and are these markets truly decoupled from the rest of the world? Writer Charlie Corbett

"Do or die time for the greenback?" screams the headline on a foreign exchange (FX) research note issued as The Banker went to press. The headline was inspired by heavy losses that week on the dollar against the pound and New Zealand dollar.

In many ways, however, the comment neatly sums up a wider debate about the long-term strength of the dollar, and other developed market currencies, versus ascendant emerging markets currencies. Talk of a fundamental shift away from the dollar as the international reserve currency of choice is absurdly premature but the mere fact that it is the topic of so much debate raises more fundamental questions about how the international currency markets are evolving.

Emerging currencies

The traditional currency pairs to which traders have become so used, and where most liquidity lies, could gradually be coming under threat from more ascendant currencies. In particular from countries in emerging markets and those economies that have abundant supplies of commodities. One of the most heavily anticipated currency decisions for a generation of traders will come not from a developed country, but from an emerging economy. The decision on when, and indeed if, the Chinese government decides to allow the renmimbi to appreciate is critical to kick-starting growth in Western markets - and one which has the entire financial community in developed markets biting its fingernails.

Axel Pierron, senior vice-president of European markets for FX research firm Celent, says there is more and more investment flow and interest in emerging markets currencies. "This is a major change from a few years ago where most of the liquidity was on the most popular currency pairs. This will give opportunities to those Tier 2 brokers that have knowledge of and network in local markets," he says.

The long-term future, according to many FX specialists, is in the trade of the once exotic, now increasingly mainstream emerging markets currencies. The BRIC economy currencies are popular like never before. "I think the growth forecast for the developed countries is slower than the emerging markets. Those economies will continue to expand and the currencies will continue to appreciate," says Scott Wacker, head of FX sales for EMEA at JPMorgan.

The recent sovereign debt crisis in Greece has also shaken confidence in Europe's single currency and lent weight to the argument that growth and stability might lie away from developed economies. Sterling has weakened heavily of late also, and the yen remains a victim of Japan's heavy debt burden. In terms of the euro, one senior FX trader believes it will ultimately pass the test it is going through but that the recent Greek crisis sparks a more fundamental question. "What the current crisis has shown us is that there needs to be a stronger mechanism within Europe to make sure one of the regions doesn't lag the rest, because it pulls the whole region down," he says.

cp/80/GET-EU flag Greece.jpg

Sovereign crisis: protesters in Athens set fire to an EU flag as they demonstrate against the austerity measures announced by the country's government to satisfy its EU partners

The cautious view

Not everyone, however, is quite so confident in the emerging markets story. Others take a more cautious view. David Woo, head of global FX strategy at Barclays Capital, agrees that the most important development of the year so far is the general weakening of European currencies and the dollar against emerging markets currencies but, he says, the risk is the market could be wrong.

He points out two assumptions that could and should be tested in the months to come: "Number one, the assumption that the fiscal problem is European-specific, and number two, that should this crisis become more widespread, that the emerging markets can continue to decouple from it."

The biggest risk, according to Mr Woo, is that 2010 will see payback for the massive increase in leverage in government balance sheets. "Greece is not alone. The US, the UK and Japan will all be vulnerable," he says. Of particular concern is the imminent end of the US Federal Reserve's (Fed) asset-purchase programme. Last year, the Fed purchased $1500bn worth of US assets. This meant the huge increase in fixed income securities issuance in 2009 could be soaked up. "When the programme ends, the bond market may struggle to cope with the increase in supply. This can serve as a catalyst for renewed worries about sovereign risk," says Mr Woo.

It is a similar story in the UK. The Bank of England has bought an estimated £200bn ($300bn)-worth of gilts during its asset-purchase programme. Now that the Bank of England has paused its quantitative easing programme, that means the market will effectively have to find an extra £200bn this year to fund the UK budget deficit.

At first sight this appears to back the theory that emerging markets currencies are the best bet for future growth. However, Mr Woo points out that the bottom line is that sovereign risk will likely take on a global dimension in 2010, which will have a wider impact on the growth prospects both for emerging- and commodity-based economies. "[In] the first three months of the year, the market has had a foretaste of what a sovereign crisis could be like - that was Greece. The risk is that the Greece crisis will take on a global dimension," he says.

The decoupling question

Ultimately however, without recourse to a crystal ball, it is impossible to say what the future holds. Suffice to say that 2010 has already been a volatile year for global currencies and looks likely to continue in that vein. While interest in emerging markets currencies is at an all-time high, the argument that they are truly decoupled from developed markets is a thin one. The dreaded double-dip in developed economies, which many fear is likely in 2010, will have an impact globally. Many traders believe the commodity currencies are already overvalued and that they are due for a fall. Others are betting that currencies in more developed nations have now plumbed their lows and will increasingly appreciate as the year wears on.

The Fed's decision to end the asset-purchase programme is seen as a positive tightening move, despite US interest rates remaining at rock bottom, and this will lead the US currency to appreciate. Sterling is in many ways a hostage to electoral fortunes as investors await the result of the UK's general election in May, and hope that there is not a hung parliament.

However, some believe that the worst could already be behind the pound. "Sterling will plumb the depths going into the election. But the pound has already taken its beating. At some point it'll find the bottom and then it will stay stagnant or appreciate slightly," says one head of FX sales.

In terms of the yen, many fear that its long-term future is to drag along the bottom, a victim of the country's huge debt burden. Others, however, are more positive about its prospects. "A lot of people like to think that Japan will be most vulnerable to the crisis. But I disagree," says one head of strategy at a major commercial bank. "The sovereign risk we are talking about is not about default risk, but about refinancing risk. The Japanese government is not that dependent on external financing of its debt, to the extent that just 5% of Japanese government bonds are held by foreigners. Japan has the lowest refinancing risks of all the major economies."

The world will continue to hold its breath as investors wait on China's decision when and if to revalue its currency. This, perhaps more than any other facet, is an indication of where the future of global financial power will lie.

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