Emerging market currencies – Don’t call this a comeback
EM currencies, which rallied sharply between mid-January and mid-March, have run into a brick wall and the risk is tilted towards depreciation in coming weeks. In terms of likely catalysts, the list of “known-knowns” seems to be growing and the list of “unknown unknowns” may also be rising in tandem.
Markets remain unconvinced that the US economy can power the rest of the world while at the same time fretting that a Fed hike is still on the cards.
Add to this debilitating dilemma less attractive valuations, particularly for commodity-currencies, falling oil prices and a growing list of political scandals.
The backdrop of a too-tough-to call UK referendum on EU membership in June and US elections in November is only likely to add to EM currency woes.
In Non-Japan Asia, precedent suggests that central banks are unlikely to step in the way of modest FX depreciation given generally subdued exports and inflation. At the very least they are likely to intervene in the FX market to slow any currency appreciation, particularly where FX reserves are modest.
If the pressure on EM currencies becomes acute, high-yielding commodity currencies (BRL, IDR, RUB) may well underperform. Conversely, NJA currencies may do relatively better as NJA central banks still have the firepower to lean against rapid and/or sustained depreciation.
EM currency rally has run out of steam
A GDP-weighted basket of emerging market currencies, including Non-Japan Asia (NJA), has been flat-lining since 17 March (the day after the Fed meeting) against a range-bound US dollar, according to my estimates (see Figure 1).
Only the MYR has significantly appreciated, with the Nominal Effective Exchange Rate (NEER) up a further 3.4% since 17 March (see Figure 3).
This follows an EM currency rally from mid-January to mid-March, during which the commodity currencies (bar the ZAR) outperformed, as did the SGD in NJA (see Figure 4). The CNY and INR heavyweights underperformed, with large capital outflows from China well documented.
Risk is of EM currency depreciation as markets and central banks grapple
The risk in coming weeks, and in particular as we get closer to the Fed policy meeting on 15th June and UK referendum on EU accession on 23rd June, is that EM currencies start to weaken for reasons which are ultimately familiar.
First, I expect equity and bond inflows into EM economies to slow further, after surging in March to $36.8bn (substantially above the 2010-2014 average of $22bn) according to the International Institute of Finance. The catalysts include a divided Fed in the face of lukewarm data, stretched currency valuations, falling energy prices and EM-specific concerns.
- Macro data are not strong enough to give markets confidence that the US or any other economy for that matter can steady global GDP growth which likely slowed to a six-year low of around 2.7% year-on-year in Q1 (see Figure 2). The US manufacturing sector is still struggling while China’s banks are under clear strain. But macro data are also insufficiently weak for markets to believe that the US Federal Reserve will not hike rates again (US, Japan and UK Q4 GDP growth was revised up, and US employment and manufacturing/services ISM ticked up in March). As a result Fed Chairperson Yellen’s dovish rhetoric has been countered by other FOMC members’ more hawkish comments and lost its potency (See Right said Fed, 18 March 2016).
- The attractiveness of commodity currencies, including the Brazilian Real, Malaysian Ringgit, Russian Rouble and South African Rand, has arguably faded after their sharp rally between mid-January and mid-March. While they offer high carry in a low-yielding world, history has shown that a tumbling currency can wipe out a year’s worth of carry in only a few trading sessions.
- Oil prices have decoupled from still-rising US equities due to a combination of weak global demand and seemingly little appetite for a freeze in global supply, with Saudi Arabia and Iran at loggerheads. This is in turn raising concerns about the economic health of large EM commodity exporters.
- A number of commodity-exporting economies are also dealing with ongoing scandals threatening their leaderships. Brazilian and South African Presidents Rousseff and Zuma are both facing potential impeachment, Malaysian Prime Minister Razak is fighting allegations of misappropriation of funds and Icelandic Prime Minister Gunnlaugsson has resigned following allegations he concealed investments in an onshore company.
Non-Japan Asia central banks unlikely to stand in the way of modest FX depreciation
Furthermore, while the merchandise trade picture in NJA has become somewhat more granular than it was during the uniformly “weak exports, weak imports” period in mid-2015, NJA trade balances have not changed much (see Figure 5). They have therefore offered little extra marginal support to NJA currencies. Specifically, trade balances have either deteriorated slightly in the past three months (in India, Indonesia and Singapore), or only improved marginally (in China, Korea, Malaysia Philippines and Taiwan), Only Thailand’s trade surplus has materially increased.
Finally, I would not expect NJA central banks to stand in the way of modest currency depreciation and at the very least limit any appreciation in order to improve export competitiveness while not being overly concerned by inflation at this juncture (see Figure 6). There is also scope for NJA central banks to cut policy rates further, as I first highlighted Asymmetric risk to emerging market monetary policy (6 August 2015), although they may wait to see what the Fed does at its June meeting.
Specifically, in Singapore non-oil domestic exports remain weak and core inflation subdued. I see a possibility of the Reserve Bank of India (RBI) and Bank Indonesia (BI) intervening in the FX market (buying FX). Their FX reserves are modest relative to their peers (see Figure 7) and core inflation remains well below historical averages (see Figure 6).
Bank Negara Malaysia (BNM) is in somewhat more of a bind but the risk is likely tilted towards BNM capping, or at the very least slowing the recent pace of MYR appreciation. While core inflation is currently double its 2010-2015 average, Malaysia’s trade surplus has flat-lined while the USD-value of its FX reserves has fallen sharply (see Figure 7).
The pace of monthly change in a GDP-weighted basket of NJA NEERs, excluding the CNY, has already turned slightly negative from a peak of about +2% three weeks ago – very much in line with historical patterns (see Figure 9). This reasonably regular pattern of modest appreciation/depreciation partly reflects ebbs in flows in capital, cyclical/seasonal patterns in current account balances but also central banks’ efforts to smooth the paths of their currencies. History, it if repeats itself, suggests that the level of this basket may grind lower in coming weeks.
At the same time, history suggests that if the sell-off in EM currencies proves acute rather than modest NJA central banks will dip into their FX reserves to slow the pace of depreciation in their currencies, which I would therefore expect to outperform their EM peers.
Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.
 I thank Ed Stirling for kindly allowing me to use this most appropriate quote.
 I include Korea and Singapore for the purpose of this analysis even if these two countries are arguably developed rather than emerging – see Emerging Markets falling between the cracks (and BRICS), 5 March 2015.
 The Brazilian Real is the only major EM currency which has appreciated faster in nominal effective rate (NEER) terms than versus the US dollar, according to my estimates. This is due to its sharp rally versus the Argentine and Mexican pesos which account for about 10% and 4%, respectively, of the BRL NEER.