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The currency ceasefire

When, in December, Brazil withdrew its IOF tax on foreign investments in Brazilian equities many breathed a sigh of relief – not just for the marginal benefits that the removal will have on the poorly performing Bovespa, but because it could be seen as the end of the currency wars. The rapid appreciation of emerging market currencies had led Brazil to introduce a range of capital controls aimed at stemming the capital inflows that pushed the real to $1.50.

When the European crisis threatened to send Europe, the UK and even the US back into recession, the flight to safety – in particular the US dollar – meant the problem went away. The real (to stick with Brazil for consistency, although the phenomenon spanned many emerging market currencies) fell to $1.90.

This ceasefire in the currency wars will be temporary. When global growth resumes, the conflicts will resume because the underlying cause – the convergence of emerging and developed market economies – will resume. If anything, the fundamental convergence in risk between the two has been accelerated by the crisis. As HSBC notes in its report The big convergence: "The lines between the risky and the supposedly risk-free are blurring, and this will have a significant consequence for allocations of capital around the world."

Indeed, despite recent commentaries about the ascent of the emerging markets, they still take a very small proportion of international investors’ capital. For example, Bank of America Merrill Lynch’s Global Bond Index has 5.52% allocated to emerging markets (as of November 2011). The BarCap Global Aggregate Bond Index has 3% invested in emerging markets and the Citi World Government Bond Index has 1.51%.

Improving credit metrics and ratings in the emerging markets, a desire for diversification and the inclusion of more emerging markets in the globally traded indices should lead to a big reallocation of portfolios to emerging market exposures. For example, since 2000 seven emerging markets have reached investment-grade status (including Brazil, India and Russia) while since 2006 four developed countries including the US have lost triple-A ratings from at least one agency, and two developed nations, Greece and Portugal, now have junk ratings. The spread between emerging market sovereigns and US high-grade bonds narrowed from about 535 basis points on average between 2000 and 2004 to 124bp in 2011. Another eye-catching stat from the HSBC report: the average volatility of emerging market hard-currency debt has not changed between the periods 2003-05 and 2009–11; that of the US high-grade and high-yield bonds increased between 50% and 100%.

Very low yields in developed markets will also drive inflows to emerging markets as investors hunt alpha. In fixed income, emerging market sovereigns returned about 460% between 1994 and October 2011, more than double the return from US treasuries or developed market bonds – all achieved with little added volatility.

The recent crisis has probably for ever changed the underlying risk perception of countries. Developed markets were deemed risk-free because historically they hadn’t defaulted. Rising debt levels were tolerated. Meanwhile emerging markets were considered risky because previous crises could lead to defaults. The fact that emerging market economies had grown (with a GDP growth of 6.5% in the past 10 years compared with 1.6% for developed economies), de-dollarized (giving counter-cyclical flexibility in fiscal and monetary policy), and built up foreign-currency reserves (the largest 20 emerging market countries have accumulated $5.5 trillion of reserves) was overlooked.

A novelty of the past two crises has been the emerging markets’ ability to implement economic policies to bolster growth against the economic headwinds from abroad. From now on, it is likely the credit assessment applied by investors will be more a function of looking forward, favouring increased allocations to emerging markets.

And looking forward, the share of emerging market assets in global investors’ portfolios is estimated to grow from between 5% and 7% currently. If there is just a marginal increase in allocation, it will have a powerful impact on valuations and reductions in funding costs for corporates and sovereigns in those countries. And as foreign participation increases, so capital will flow into emerging markets, and these same forces that lower the emerging market risk premium will also drive currency appreciation.

As the global economy recovers, currency wars will return; countries will rebuild barriers to capital inflows to keep their exports competitive, limiting the potential of global recoveries as soon as they begin. Is it possible that capital account openness has now become just an established counter-cyclical policy tool?

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