The prospect of higher treasury yields as the Federal Reserves September meeting approaches and the central bank potentially decides to taper its asset purchases is exposing the cracks in emerging market financial systems.
That has put emerging market currencies under pressure, especially those of countries sporting current-account deficits such as Brazil, India and Indonesia.
Simon Derrick, head of currency strategy at Bank of New York Mellon, says foreign-currency reserve growth among developing nations has served as a useful proxy for the pace of inflows from the dollar that have done so much to support emerging markets since 2002.
He says, however, that it is clear that since the summer of 2011 a number of the emerging markets nations have seen a marked slowdown in their quarterly foreign-currency reserve growth among them Brazil and India.
Derrick says that is likely to have been exacerbated in May, when Ben Bernanke, Fed chairman, first floated the possibility that the central bank might move to scale down its quantitative easing programme.
This slowdown in the pace of inflows has, in turn, helped expose those nations running significant and expanding current-account deficits to the market sell-off that has emerged since May, he says.
In Asia, that has rekindled memories of the financial crisis of 1997-98 and raised the question of whether local authorities have sufficient foeign-currency reserves.
That is especially true in India and Indonesia, where, in addition to currency weakness, bond spreads to treasuries are priced much wider than in the rest of non-Japan Asia and sovereign CDS spreads have also ballooned higher in the last couple of weeks.
Asia ex-Japan bond spreads to 10-year Treasuries (bp)
The pressure on these currencies begs the question of whether local authorities have sufficient foreign-currency reserves to withstand this pressure, says Chris Turner, head of FX research at ING Financial Markets. During the Asian financial crisis, foreign-currency reserves were seen as woefully inadequate, particularly in relation to external debt.
Much economic literature has emerged since the Asia crisis on this topic, from which three conventional measures of reserve adequacy have emerged. According to these, foreign-currency reserves should cover, first, at least three months of imports; second, at least 100% of short-term debt; and third, at least 20% of broad money.
ING analysed the situation among emerging market Asian currencies. As can be seen in the chart below, all currently broadly meet the basic criteria.
However, as Turner notes, relative to their peers India and Indonesia are on the lower end of the coverage spectrum, and Indian foreign-currency reserve coverage of broad money assessing the risk of deposit flight is marginally below the threshold at 17%.
|Three conventional measures of FX reserve adequacy|
Still, just because the alarm bells are not ringing right now does not mean the situation cannot change.
Some observers believe emerging market currencies and US treasuries are vulnerable to a vicious cycle of self-reinforcing rising yields and FX weakness.
Marcus Huie, rates strategist at Bank of America Merrill Lynch, says this has been formed by the shift in causation between the treasury market and the emerging market currency markets.
He says that initially, growing expectation of the initiation of Fed tapering in September drove yields higher, which in turn led to the selling of emerging market currencies.
However, recent emerging market currency declines have fed fears of central bank reserve selling and led to rising treasury yields, says Huie. This two-way causation raises the risk of a self-reinforcing cycle between the bond and currency markets, where the treasury reserve assets are themselves vulnerable to losing value.
So far there has been little statistical evidence of large-scale reserve liquidation, with emerging market central banks fighting currency weakness with a range of supportive measures, from raising interest rates to intervening in the forward market.
Indeed countries that report the value of their reserve portfolios with a relatively high frequency, such as Brazil, Russia, India and Turkey, have not exhibited sharp falls since July. Only Federal Reserve custody holdings data have shown a steady fall in the face value of official treasury holdings in the past few months.
The latest reserve data, which coincide with the accelerated emerging market currency sell-off of the last two weeks, may make more interesting reading, however.
Fed Treasury custody holdings decline, potentially indicating central bank liquidation
Huie notes there are differences and similarities between the current situation and that during the Asian financial crisis.
He says the differences are that central bank reserve portfolios now act as a substantial buffer, exchange rate regimes are more flexible, and financial systems are less vulnerable to obvious asset-liability mismatches.
On the other hand, the expansion of domestic credit as a share of GDP is comparable, the degree of monetary accommodation has been unprecedented, and the vulnerability of reserve portfolios to rising developed market yields could be an aggravating factor as well, says Huie.
There is of course one institution that could break the cycle between emerging market FX and treasury yields: the Fed.
Delaying its decision to start tapering its asset purchases could give the market more time to adjust and, in turn, reduce the current volatility in emerging market currencies and the potential for a further rout in asset markets.
Bernanke has said after all that he is monitoring broad financial conditions, which could be damaged by sharply rising yields. Equally, however, he has also said higher yields reflect underlying economic conditions and that the unwinding of trades that were based on the premise of unsustainably low yields was not unwelcome.
Ultimately it is likely that domestic, not international, economic conditions will persuade the Fed to go ahead with its tapering plans. That might well spell more volatility for emerging market FX.