Emerging markets offer exotic exchange

These are exotic times for foreign-exchange traders. Eastern Europe offers a range of apparently one-way convergence bets with the euro, while liquidity is flowing into such supposedly exotic alternatives as the South African rand, the Brazilian real and lately, the Chilean peso. Will the trend continue, and if so, what’s the best way to play it?

Convergence looks easy. Ulrich Leuchtmann, FX manager at Invesco Asset Management, says: “Bonds in those currencies hoping to join European monetary union will have to come to eurozone yield levels; therefore, a lot of positive price actions will have to come sooner or later. Also, the currencies will have to appreciate to get [retail and other] prices to EU levels.”

The alternative to currency appreciation would be inflation, but, as Mr Leuchtmann says, “they won’t want that after the high inflation of the 1990s”.

Short-term volatility

The Hungarian forint, the Polish zloty, the Czech koruna and the Slovak koruna head the list of convergence plays, but none of them is as easy as the long-term rationale suggests. The problem is that although the long-term picture looks promising, the short-term reality is fraught with volatility. Juliette Declercq, FX strategist for emerging markets at JP Morgan, says: “The market opened 2003 with an extremely large position in the Hungarian market, based on a bet that the central bank would revalue. Instead, rates were cut massively and the two-week repo rate was closed. This prompted a major sell-off. You could see a 50% move in a day followed by a 5% reverse over the next two days.”

That wasn’t a one-off. Ms Declercq says: “In June 2003, Hungary devalued. The band changed from 235 to 315, to 240 to 320. A small move, but the fact of doing it persuaded the market to unload its position. Again, we saw a 10% move in the currency.”

 Juliette Declercq: ‘At times of stress, liquidity dries up and it’s much more difficult to get out’ 

Such movements might seem attractive to some FX participants, but the flaw lies in what they do to liquidity. As Ms Declercq suggests, there is a difference between normal time and stress time. For example, in normal conditions you could trade 50 million, 100 million, up to half a billion euros of position [in a convergence currency], “but at times of stress, liquidity dries up and it’s much more difficult to get out”, she says.

Real appreciation

Getting stuck like that could kill a short-term trader. Mr Leuchtmann, taking a long-term view, sees a positive side. He says eastern European currencies must see a real appreciation in the long run. “If a currency weakens, that is potentially an opportunity to add it to your portfolio very cheaply, if you can hold it for a couple of years.”

A big if. But even here, there’s a problem. Paresh Upadhyaya, currency analyst at Putnam Investments, describes himself as a “structural bear” on the eastern Europeans. He says: “When I look at Hungary, for example, there’s a large current-account deficit and a large budget deficit. Inflation is likely to pick up next year. Also, the central bank and the government are doing a very poor job; the former wants a strong forint, while the finance department believes it should be weaker. It’s not clear that these guys know what they’re doing.”

 Paresh Upadhyaya: ‘Eastern Europeans aren’t the only opportunities worth considering’ 

Governmental concerns

Surely governmental inefficiency is attractive, at least to short-term traders? Mr Upadhyaya has his doubts. He says if it is combined with other factors that highlight the fact that the fundamentals are deteriorating, it could be a very messy situation.

Mr Leuchtmann has a slightly different take on that. He believes Hungary represents a classic dilemma. The central bank targets the exchange rate as a major tool, and on the other side the finance minister would like to see a weaker forint to boost local business. Hungary is, after all, very export-driven. He extrapolates the lesson that in the convergence currencies, one has to look very deeply at the economic fundamentals and also at statements from the central bank and the government. “[It] is very different from major currencies, where economics don’t play a very crucial role,” he says.

Asian attractions

The same is true for all emerging-market currencies, and with that in mind, Mr Upadhyaya suggests that the eastern Europeans aren’t the only opportunities worth considering. He says: “In many cases, and particularly in Asia, you have a robust domestic economy. In Korea, Taiwan, Thailand, India, China and Japan the economies have bottomed and are on the rebound. That helps drive the equity market, which in turn brings in portfolio flows and thus puts upward pressure on the currencies. That’s where liquidity has been improving over the course of the last year. Equity flows have been big drivers.”

Positive factors

Mr Upadhyaya concedes that Asia has also seen some central-bank resistance to currency strength (mentioning the Thai baht in particular in this context), but the point is attractive: that without there having to be direct correlations, any factors conducive to inward capital flows act positively for the currency.

As does liberalisation. Paul Chappell, managing director of FX trader C-view Limited, says the world is trying to move towards gradual liberalisation of emerging currencies and greater convertibility. The ones that are particularly attracting the attention are the BRICs: Brazil, Russia, India and China. Not least in terms of population size, they are the new economies. “There is a strong desire that their currencies become, over time, fully floating and fully convertible,” he says.

They are, as it were, convergence plays with the “emerged” FX market. But if the big preoccupation here is liquidity, and particularly liquidity through bad times as well as good, it follows that a really compelling case would need more than just inward capital flows and non-interventionist governments. Otherwise, that “wall of money” will just come to represent a potential future outflow.

Happily, there is more. The signs are that the emerging-market end of the FX market is broadening out to involve new participants. In a comparison of its 2001 and 2003 annual surveys of FX users (surveying about 2500 users, of whom about two-thirds are corporates), Greenwich Associates found usage increases as follows: Hungarian forint up 4%; Singapore dollar and Czech koruna up 3%; Polish zloty, Brazilian real and Mexican peso up 2%; South Korean, Chinese, Taiwanese, Slovak and Russian currencies up 1%.

That isn’t all. Greenwich Associates found that, corporates’ behaviour is quite different to that of financials. In virtually every emerging currency, there has been an increase in usage by corporates and a decrease in usage by financials. The one exception is eastern Europe, where both sides have increased their use of FX.

Let’s guess that the financials see the convergence opportunity in eastern Europe and nothing equivalent elsewhere. As to the corporates, this may be globalisation at work – and you could propose a direct correlation between foreign direct investment and equity markets on the one hand, and currency appreciation on the other. But what matters is, first, the variety of players bringing liquidity, and second, the proportion of them, the corporates, who are not playing to win, but to reduce risk. With them in emerging markets, not all the liquidity would be equally vulnerable to any negative impact. Their effect would be to dampen volatility.

There is one other factor to consider. Craig Reeves, managing director of Platinum Asset Management, says: “If you get it right, you can make a fortune [because] there are fewer people watching and trading those markets. It’s great when a currency is going up and you’re making money.” And very much less great, Mr Reeves says, when it’s going down. He adds: “It’s also very difficult to value an emerging-market portfolio and to quantify VaR.”

 Craig Reeves: ‘If you get it right, you can make a fortune [because] there are fewer people watching and trading those markets’ 

Exotic currencies potentially compromise the oversight process as well as add risk, because they don’t provide the same information flow as the majors. It’s not always easy to know the size of the risk you’re taking.