Devil is in the detail in EM currencies
It has been a horrible few months for emerging market (EM) currencies, with foreign exchange investors looking to exit a broad range of exposures from Brazil to Indonesia. However, a closer examination of the EM landscape reveals that among the detritus are currencies that look set to outperform.
The Brazilian real has lost about 11% to the dollar this year to trade at four-year lows, and the Colombian and Chilean pesos have slid more than 9% and 6% respectively. The Indian rupee fell to a record low, losing 16% against the dollar, with the Indonesian rupiah was down 12% and the Turkish lira nearly 13% The MSCI Emerging Markets Currency Index, which tracks the performance of those countries’ currencies relative to the US dollar, has fallen by over 5% since its high in early May.
The MSCI Emerging Markets Currency Index, which tracks the performance of 25 EM currencies relative to the US dollar, has fallen by more than 5% since its high in early May.
The catalyst for the declines has been signals from Federal Reserve chairman Ben Bernanke that the central bank would look to taper its massive bond-buying programme later this year, removing billions of dollars of cheap funding, much of which has found its way into EMs.
Since May, EM bonds have seen 13 consecutive weeks of outflows, according to EPFR data, extinguishing gains made in the first part of the year. Outflows from EM equity funds are almost $5 billion year-to-date, EPFR says.
Among EM currencies, Morgan Stanley’s strategists named South Africa’s rand, India’s rupee, the real, rupiah and lira the “fragile five”. Still, investors should beware tarring all five with the same brush, some analysts say.
“If you look at the ability of governments to defend their currencies, you will find that their capabilities are extremely variable,” says Thierry Apoteker, CEO at EM consultancy TAC Financial.
One measure of a country’s ability to stave off currency weakness is its level of foreign currency reserves, and on that count some of the most punished countries have powerful stores of ammunition, which could be employed to stem further declines.
Two countries with a vast pool of reserves are Brazil and India. India had $257 billion of foreign currency reserves at the end of July and Brazil had $370 billion.
The extent to which a country can use its reserves to defend its currency is determined at least partly by its FX borrowing requirement, a function of its current account.
“With less liquidity in the market, those countries that demand a lot of inflows are being hit hardest,” says Michael Sneyd, an FX strategist and lead quant strategist at BNP Paribas in London. “Investors become a lot more selective between those and countries that have current account surpluses like South Korea and Taiwan.”
Even among the fragile five there is a degree of granularity, analysts say.
Another tool for defending a currency is monetary policy, and in this area Brazil and India diverge.
The slowdown in the Indian economy during the past year – the country grew at 4.4% in the three months to June, the slowest rate since 2009 – leaves the central bank with little room to raise interest rates.
New bank head Raghuram Rajan, a former chief economist at the IMF, is thought to be more of a hawk than his predecessor, but has little wiggle room as India struggles with structural issues.
Brazil on the other hand is in a good position to pull the interest rate trigger, alongside the $55 billion to $60 billion of reserves it has already said it will employ to support the real. The inflation rate in Brazil was 6.27% in July, at the upper end of the bank’s target range, and policymakers have already set off on a path to higher rates.
“Brazil is in a great position to protect its currency if it wants to, whereas India is less well-equipped and probably has a similar level of capability to Indonesia, which does not have the same reserves as India but is in a better position to raise rates,” says Apoteker.
The country facing the biggest challenge in terms of defending its currency is Turkey, which is vulnerable in terms of its available foreign reserves and ability to raise rates, which could lead to a substantial economic slowdown.
Away from the fragile five there are several points of light. Currencies such as the Chinese renminbi, the Taiwanese dollar, Korean won and Philippine peso have been relatively less impacted by the Fed-tapering story.
For relative-value players, the opportunities in EMs have not gone away yet.