What’s been happening?
The Emerging Market currencies have been experiencing increased volatility lately. This has been due to a combination of the strengthening dollar as well as deteriorating trade relations. While the broader Emerging Market currencies were facing increased volatility since 2018, matters were exacerbated in August with the tumble of the Turkish Lira. This resulted in volatility spiking to a two-year high and brought with it fears of whether an emerging market crisis is on the horizon.
The current round of emerging market currency depreciation has been geographically diverse and affected countries all around the world. Be it Asia, Latin America (LATAM) or Central and Eastern Europe, Middle East and Africa (CEEMA) nations all over the globe are facing a depreciation in their currencies. Within the groups though Asian currencies are holding up to the headwinds blowing around the globe better than their compatriots in LATAM and CEEMA. As US treasury yield continues to rise “hot money” is expected to move to US markets to avoid the inherent present in emerging markets. This is a phenomenon which is widely seen whenever the Fed is on a hiking cycle. The impact across countries however varies depending on the underlying fundamentals of the countries economies. We try to take a closer look at the various currencies by examining current account balances, fiscal budget, real GDP growth and inflation across countries. The currencies are divided into three groups based on the region:
|Chinese Renminbi, Indian Rupee, South Korean Won, Malaysian Ringgit, Taiwanese Dollar, Indonesian Rupiah, Philippine Peso, Thai Baht
|Turkish Lira, South African Rand, Russian Ruble, Romanian Leu, Polish Zloty, Czech Koruna, Hungarian Forint
|Argentine Peso, Mexican Peso, Brazilian Real, Colombian Peso, Peruvian Sol, Chilean Peso
Asian Currencies perform better than their worldwide counterparts in the emerging markets.
The precipitous drop of the Turkish Lira of 30% in the span of three days attracted attention from all over the world. It also led to many questionings whether an emerging market currency crisis was finally upon us. The question is certainly one with merit. While the drop of the Turkish Lira might have been the one to turn on the spotlights it is far from the only one under pressure. In Latin America, the Argentinian Peso and the Brazilian Real have dropped 37.65% and 16.66% respectively since the start of the year. Over in CEEMA the South African Rand and Russian Ruble give the Turkish Lira company having fallen 14.33% and 14.14% respectively in 2018. The Asian currencies have been a bit more resilient to the pressure with the Chinese Renminbi, Indian Rupee and Indonesian Rupiah dropping 5%, 8.2% and 6.94% respectively so far in 2018. The figure for the Chinese Renminbi however does mask the fact that since April it’s drop has been around 10% garnering increased attention from market participants. The pressure on the emerging market currencies is clearly spread across the globe and not constrained to a region or set of countries.
YTD spot price return of global major currencies
EM Currency Performance by Region YTD
Are the Fed’s actions ensuring money flows back to the US market?
Turkish President Erdogan’s constant ministrations that the United States is to blame for his country’s financial crisis aren’t without some merit, however the political confrontation with the United states is only part of the reason for the pressure on the Lira. The real threat to not just the Lira but emerging markets overall has been the Fed’s continuation of the rate hiking cycle. The cycle began in late 2015 but sped up in 2017 and has resulted in 7 rate hikes so far. This has meant that the upper bound of the Fed Fund Rate has now reached 2%, which has pushed up the yield of the 2-year US treasury to more than 2.5% annually. These factors have led to investor money flowing to the US markets from emerging markets. Looking at the EM bond market ETFs could provide us with some evidence for the EM market money outflow. The below bar chart sums the fund flows from iShare JP Morgan EM Local Government Bond ETF and VanEck Vectors JP Morgam EM Local Currency Bond ETF. It clearly shows that money has been flowing out of emerging market since April 2018.
Yield of US 2Y Treasury high enough to attract money out from EM market
Money flow out from EM market since April 2018
This outflow of money results in a double whammy for countries bearing heavy foreign currency debts especially ones denominated in the US dollars. The outflow reduces the demand for local currencies at the same time strengthening the value for safe-haven currencies. Most countries can’t cope with the resulting pressure and this sends their currency tumbling. The JP Morgan Emerging Markets Currency Index has sunk more than 12% since March 2018.
Dollar Index negatively correlates with Emerging Market Currency Index
Not many effective ways to defend currencies in a strong dollar environment
Theoretically, when one currency is facing depreciation pressure, the local central bank could raise interest rates to attract demand of the currency and thus maintain its value. However in the real world this method has always lost its magic during strong dollar cycle especially in economically weak countries. The below table illustrates this by comparing the spot return on the currency with the interest rate return across major emerging market economies.
Currency with highest interest returns
|South African Rand
Mexico stands out as an exception as the Mexican Peso has recovered recently with progress on the NAFTA renegotiation front causing a sudden jump in its value and allowing it to recover the loss caused by Trump’s threat of shaking up Mexico’s political system between April and June.
Asian currencies perform better than peers due to stronger economic fundamentals
While a strong dollar is bad news for the performance of emerging market currencies across the board the countries with weaker economic fundamentals get the hardest. For our analysis we have used current account, fiscal budget, real GDP growth and inflation to understand a country’s economic health. The Asian countries form the most economically sound group with relatively healthy current account balances, prudent government spending, contained inflation level, and substantial real GDP growth rates.Indonesia is probably the weakest spot in Asia as the country has twin deficit issues (current account deficit and government budget deficit) with lacklustre real GDP growth not helping matters. India also has twin deficit issues, but the country has managed to have high real GDP growth rate to compensate, so investors seem to have higher tolerance for the weakness of other data for this country. One thing to notice for India is that it is highly reliant on crude oil imports. Higher crude oil prices will negatively impact real GDP growth. The Turkish Lira’s slump was due to happen even without their confrontation with the US administration. Even though the country has a relatively high growth in real GDP, it’s current account deficit and government budget deficit is too large to make investors feel safe in a dollar interest rate hiking environment. The fact that the country’s foreign reserve level dropped since 2014 doesn’t help with preventing investors from flying out of the country for sure.The South Africa Rand is another one that has us worried. South Africa has gone through political instability in 2016 and 2017. Even though the currency rebounded in late 2017 and 2018 Q1, the new government couldn’t prove they can turn the country onto the right track. The South Africa government has begun the process of seizing land from white farmers on 20th August, which risks pushing the country into chaos again. Besides the political tension, the economic fundamentals of South Africa don’t look good either. The country’s current account deficit to GDP is 3.15% and the government deficit to GDP is 4.38%. The real GDP is only 1.33% while headline CPI is 4.6%. We think the risk is high that the country’s currency will continue to tumble. The twin bright spots in CEEMA are the Czech Republic and Poland with sound economic fundamentals. As the Turkish Lira slump dampens the investment sentiment in this region (even euro is under collateral damage), we think if these two countries’ currencies are brought down as a result of broader sentiment, it could be an opportunity to speculate on their eventual rise due to their sound economic underpinnings. In general, the LATAM groups’ economic data is the least attractive. There could be a recovery in the offing in Brazil as the current account balance has improved substantially, but the large government deficit means it might be too early to jump into this market. Not to mention the country’s election is still too cloudy to predict. Current account records the balance of trade between a country and its trading partners. A Current account deficit shows that the country is spending more than its earning, necessitating that a country borrows money from foreign resources to make up the gap. Therefore, a large current account deficit would increase excess demand for foreign currency and lower the value of local currency. Below three charts shows the current account to GDP of countries in different regions.
- In general, Asian countries have stronger current account balance, with Taiwan, Thailand, South Korea, and Malay having a relatively large current account surplus.
- India and Indonesia are relatively weak in terms of current account balance. China used to have large current account surplus, but the latest number is close to zero, meaning the current account surplus advantage is shrinking.
- In LATAM, Argentina’s current account balance has deteriorated since 2003 when the country fell into crisis. Colombia’s current account to GDP was the second lowest among its peers. Brazil’s current account deficit has been improving since 2015 and is one of the only bright spots in LATAM.
- In CEEMEA, Turkey, Romania, and South Africa have the lowest current account balance to GDP. Poland and Hungary are improving, which contrasts with Russia’s current account surplus which has been dropping.
Asian Currency Group: Current Account to GDP
LATAM Currency Group: Current Account to GDP
CEEMEA Currency Group: Current Account to GDP
Fiscal budget balance is also critical to the value of a country’s currency. Even though government spending will boost up domestic economy, countries with substantial fiscal deficits level are negative to the value of local currency because the government may print money to pay debt and thus create inflation in the economy with an excessive supply of the currency.
- In general, Asian countries have more prudent fiscal budget balance, with South Korea running a significant budget surplus and Taiwan near balance level. India and China run a larger deficit compare to their peers.
- In LATAM, Brazilian government is running a huge deficit, increasing the country’s inflation risk. Columbia’s government deficit is also relatively large. Some countries’ data such as Peru and Chile is incomplete.
- In CEEMEA, South Africa and Romania has the largest fiscal deficit to GDP.
Asian Currency Group: Fiscal Balance to GDP
LATAM Currency Group: Fiscal Balance to GDP
CEEMEA Currency Group: Fiscal Balance to GDP
Inflation erodes the currency’s purchasing power relative to other currencies.
- In Asia, the inflation level is mostly well contained. One thing to point out is that the Philippines is experiencing higher inflation over the past three years and this could put downward pressure to its currency. India’s inflation is also relatively high at 4.79%. However, as it has relatively high real GDP growth, the level of inflation is acceptable.
- In LATAM, Argentina is facing hyperinflation. Brazil and Mexico have a relatively high inflation level at 4.48% and 4.81% respectively.
- In CEEMEA, Turkey is experiencing high inflation at 15.85%. If the government does not promptly act to solve this, the inflation could trend even higher. However, right now, the Erdogan administration has ruled out increasing the interest rate and is against seeking help from IMF.
Latest headline CPI YOY in each country
Foreign investors will have relatively high tolerance to above mentioned data if a country is having high real GDP growth. Asian and CEEMEA countries have higher real GDP than LATAM countries.
Latest real GDP growth YOY in each country
Political tension could amplify difficulties
The Fed’s rate hiking cycle has resulted in almost all EM currencies embarking on a downward trend but deteriorating political stability and internationals relations could make the drop of currency value more brutal. One must simply look to Turkey as an example. The tumble of Turkish Lira in August to a large extent could be blamed on relations between Turkey and the United States. On August 10th, President Trump has increased the tariffs on aluminium and steel exports from Turkey to 20% and 50% respectively, causing the local currency to drop more than 18% in one day. Even before that, there were many confrontations between the two nations. In the beginning of August, the US announced sanctioned against two Turkish government ministers. Earlier this year, Turkey purchased the S-400 missile defence system from Russia. The US Senate then passed a bill to hold back the sale of F-35 jets to Turkey. Political risks also reside in the detention of the US pastor Brunson. Domestically, Turkey has just finished the transition from parliamentary system to executive presidential system, granting more power to President Erdogan and the AKP-led coalition. As investors are suspecting that there will be fewer checks in place for future major decision making, it could be seen as a negative to the country’s economy and currency value.
Given that the most economists expect the Fed to continue raising rates 1-2 times with in the year the emerging markets will continue to face significant pressure. With their stronger economic fundamentals, the Asian basket of currencies seem better suited to face the pressure but don’t expect the pain to get over any time soon.