That is the view of Bhanu Baweja, strategist at UBS, who has run a fundamental equilibrium exchange rate (FEER) model to assess the long-term value of currencies based on a balance-of-payments analysis.
Baweja says he set out to discover whether EM currencies could regain their poise from 2002 to 2007, or whether recent weakness is a signpost for greater disappointment ahead for investors.
“The market’s implicit expectation has been that the weakness in EM FX is temporary and not structural,” he says.
“We aim to take a big picture view on EM currencies and assess whether there is a fundamental case to be made in favour of a big appreciation in the medium to long term.”
The FEER approach sets out to estimate the change in an economy’s real effective exchange rate (REER) required to shift the current-account balance to a level matching the sustainable capital flow over time.
Baweja admits the identification of sustainable flows is more of an art than a science, but includes net FDI flows, which typically have much longer maturities and lower FX sensitivities than portfolio and other investment flows.
As can be seen from the chart below, EM currency undervaluation has been eaten away since 2007, when EM current-account surpluses were at their highest and policymakers were preoccupied with global imbalances.
“That is to script, but the fact that we haven’t seen EM currency appreciation in the interim isn’t,” says Baweja.
“The explanation goes back to the point that the correction in global imbalances has been traced through a complete collapse in EM export growth – not as the market had hoped, through strong export growth and stronger import growth in EM.”
|FEER valuations – now versus 2007|
To counter the possibility that the model was missing some structural information about the longevity of flows into EM, and hence the chance of persistent over or under currency valuation, UBS also conducted the analysis using a weighting based on previous deviation away from its five-year average.
The chart below shows that, on aggregate, it is hard to argue that EM FX is undervalued as an asset class.
|Average EM REER undervaluation over time|
“We estimate that aggregate EM currency valuation has receded to the lowest level in over 10 years and, excluding China from the analysis, there isn’t really a case for undervaluation to be made at all,” says Baweja.
|Average EM REER undervaluation over time – excluding China|
According to Baweja, the unfortunate reality is that EM has not capitalized on years of abundant G3 liquidity to enhance the quality of its capital inflows or boost productivity growth.
He says, with domestic credit substituting exports as the mainstay of growth and most EM governments prioritizing income distribution over supply-side reform, FDI and current account balances have deteriorated notably.
“In picking up the trend deterioration in basic balances, FEER also warns that the dependence on portfolio inflows, namely into debt, has picked up sharply,” says Baweja.
“Excluding these flows, few EM currencies enjoy a fundamental cushion to fall back on.”
He concedes much of these debt flows might come from a committed, long-term, investor base and therefore prove less vulnerable to exogenous shocks than investment flows were in 2008.
“That is solace for the minority of investors fearing a collapse in EM currencies,” says Baweja.
“But for debt investors currently weighing up whether EM FX can generate strong total returns even as debt inflows stall, that won’t come as a big source of comfort.”
The FEER model does not find that currencies such as the Indian rupee, Turkish lira and South African rand – all of which have recently experienced sharp drops in nominal terms – are any less overvalued from a fundamental standpoint.
Baweja believes that makes sense since in fair values constantly evolve and in all three countries, trade balances have not improved substantially, unit labour costs growth has not adjusted much and dependence on portfolio inflows has not declined.
“Inflation has eroded much of the competitiveness gain that nominal depreciation achieved,” he says.
“Moreover, export elasticities to the exchange rate are being dulled by very weak import demand in the G3. All these considerations mean spot FX has to do a great deal of work to engender current-account adjustment.”
Overall, Baweja thinks investors should expect very modest EM currency appreciation at best.
“In many undervalued regimes, continued FX accumulation may prevent nominal gains from coming through,” he says.
“In some large liquid and tradable markets like South Africa, India and Turkey, we can see sizeable declines in currency values.”
This might not, in other words, be time to jump on the EM bandwagon.