The bull case for EM FX
China’s economic downward spiral and weakening renminbi has dragged down neighbouring countries’ currencies and burnt investor appetite for emerging markets (EMs), but as currencies hit record lows and approach fair value, some market participants smell a ‘buying opportunity’.
China’s desperate response to its plunging stock market – devaluing its currency, slashing interest rates and pumping $100 billion of extra liquidity into the economy – has alarmed investors into pulling out of EM currencies and retreating to the US dollar.
Currencies such as the Malaysian ringgit traded down to 4.2950 against the dollar on Wednesday in the wake of China’s crisis, although it has since recovered to 4.2330.
Commodity currencies that have already taken a hit from falling oil prices took a second hit on the back of China’s woes. The Brazilian real, which has more than halved in value during the past few years, has weakened even further against the dollar from 3.4915 a week ago to 3.5820 on Thursday.
However, valuation indicators no longer suggest EM currencies need to weaken, according to research published on Wednesday by research house Capital Economics. It found they have weakened 11% against the dollar since the start of the year, and that most real exchange rates are below their 10-year trend.
Market jitters means snap sell-offs in some currencies are still likely in the months ahead, say market analysts. Currencies of those countries that are most sensitive to swings in short-term capital inflows, such as Turkey and Colombia, will remain the most vulnerable.
Nevertheless, many currencies do seem to have reached a “fair” value from a fundamental perspective, says David Rees, senior markets economist at Capital Economics.
“It is difficult to determine fair value,” he adds. “But various factors, such as real exchange rates and the Peterson Institute’s fundamental equilibrium exchange rates, suggest that currencies no longer need to weaken.
“I would suggest that the Czech koruna and Mexican peso look the most well-valued. Others are lower, but these are generally commodity producers and the collapse in commodity prices justifies weaker exchange rates.”
Rees is bullish on the Mexican peso, assuming the economy picks up on the back of a stronger US economy, but points out that Czech policymakers are intervening to stop the koruna from appreciating too sharply against the euro.
‘Considerable buying opportunity’
Paul Chappell, founder of currency management firm C-View, which manages in excess of $500 million on behalf of pension funds and institutional investors, makes the case for EM currencies.
“Over the medium term, there is unquestionably a considerable buying opportunity in some of these currencies,” he says.
Chappell believes a number of currencies with “reasonably good fundamentals” have been caught up in the events in China and had to weaken their currencies to remain competitive.
“There is a general sense in some parts of Asia, where there has already been substantive currency depreciation, that a number of those currencies will now stabilize,” he says.
“Korea is a good example of a country that is starting to show signs of growth, and India too, which has benefited from the reduction in oil price. Its currency has weakened over the last couple of weeks as a consequence of China, but it has been relatively strong this year.”
The most important fundamental that Chappell is keeping an eye on is economic growth. Countries that look as though they will rebound will manage to retain relatively robust currencies, in his view.
“Thailand looks as though it is maintaining relatively robust growth, and even Malaysia where the currency has been fairly badly battered is holding up pretty well,” he says.
Further monetary easing from China and stronger economic data would boost investor risk appetite for EM currencies, say analysts.
However, even currencies that look cheap based on standard value metrics, such as the Malaysian ringgit and the Brazilian real, are still vulnerable to global sentiment.
“It is still unclear if that cheapness is going to be corrected anytime soon,” says Rahul Bajoria, a regional economist at Barclays in Singapore.
Morgan Stanley is bullish on EM currencies, at least in the short-term. Global policymakers’ dovish messages, namely a refusal to raise rates, is good news for EM currencies, say its currency analysts.
However, they believe any rebounds in EM FX would be short-lived, according to research published on Thursday.
“Global liquidity can only do so much to support EM currencies, and without any fundamental improvement in growth prospects across EM, international capital will remain wary about exposure to EM where returns are likely to be limited, leaving the stability of balance of payments in question,” they state.